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International Review of Financial Analysis 36 (2014) 1–19

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International Review of Financial Analysis

Can banks individually create money out of nothing?— The theories andthe empirical evidence☆

Richard A. WernerCentre for Banking, Finance and Sustainable Development, University of Southampton, United Kingdom

☆ The author wishes to acknowledge excellent reseVoutsinas and Shamsher Dhanda. Moreover, the authostaff at numerous banks involved in this study, who havand interviews. Most of all, the author would like to thaRaiffeisenbank Wildenberg e.G., for his cooperation and acolleagues in conducting the empirical examination of bthe facilities, accounts and staff of his bank accessible tograins of wisdom be found in this article, the authorwisheof all wisdom (Jeremiah 33:3).

1 Translated into English by the author. See also Wickse

http://dx.doi.org/10.1016/j.irfa.2014.07.0151057-5219/© 2014 Published by Elsevier Inc.

a b s t r a c t
a r t i c l e i n f o
Available online 16 September 2014

JEL classification:E30E40E50E60

Keywords:Bank creditCredit creationFinancial intermediationFractional reserve bankingMoney creation

This paper presents the first empirical evidence in the history of banking on the question of whether banks cancreate money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled.Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking,banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are thenlent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediariesthat cannot createmoney, but collectively they end up creatingmoney through systemic interaction. A third the-ory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it ex-tends credit (the credit creation theory of banking). The question which of the theories is correct has far-reachingimplications for research and policy. Surprisingly, despite the longstanding controversy, until now no empiricalstudy has tested the theories. This is the contribution of the present paper. An empirical test is conducted, where-by money is borrowed from a cooperating bank, while its internal records are being monitored, to establishwhether in the process of making the loan available to the borrower, the bank transfers these funds from otheraccounts within or outside the bank, or whether they are newly created. This study establishes for the firsttime empirically that banks individually create money out of nothing. The money supply is created as ‘fairydust’ produced by the banks individually, "out of thin air".

© 2014 Published by Elsevier Inc.

“The choice of a measure of value, of a monetary system, of currencyand credit legislation — all are in the hands of society, and naturalconditions … are relatively unimportant. Here, then, the decision-makers in society have the opportunity to directly demonstrateand test their economic wisdom — or folly. History shows that thelatter has often prevailed.”1

[Wicksell (1922, p. 3)]

arch support from Dr. Kostasr is grateful to the many banke given their time for meetingsnk Mr. Marco Rebl, Director ofrranging the cooperation of hisank credit creation and makingthe researcher. Finally, shoulds to attribute them to the source

ll (1935).

1. Introduction

Since the American and European banking crisis of 2007–8, the roleof banks in the economy has increasingly attracted interest within andoutside the disciplines of banking, finance and economics. This interestis well justified: Thanks to the crisis, awareness has risen that the mostwidely used macroeconomic models and finance theories did not pro-vide an adequate description of crucial features of our economies andfinancial systems, and, most notably, failed to include banks.2 Thesebank-less dominant theories are likely to have influenced bank regula-tors and may thus have contributed to sub-optimal bank regulation:Systemic issues emanating from thebanking sector are impossible to de-tect in economic models that do not include banks, or in finance modelsthat are based on individual, representative financial institutions with-out embedding these appropriately into macroeconomic models.3

2 Federal Reserve Vice-Chairman Kohn (2009) bemoaned this issue. Examples of lead-ing macroeconomic and monetary models without any banks include Walsh (2003) andWoodford (2003), but this problemapplies to all the conventionalmacromodels proposedby the major conventional schools of thought, such as the classical, Keynesian, monetaristand neo-classical theories, including real business cycle and DSGE models.

3 The ‘Basel’ approach to bank regulation focuses on regulation of capital adequacy.Werner (2010a) has argued that this is based on economic theories that do not feature aspecial role for banks. For an overview and critique, see Werner (2012).

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http://dx.doi.org/10.1016/j.irfa.2014.07.015


http://www.sciencedirect.com/science/journal/10575219

5 See, for instance, the first BCBSWorking Paper (BCBS, 1999), looking back on the firstdecade of experience with Basel I for insights into the thinking of the Basel bank regula-tors. In a section headlined ‘Dofixedminimumcapital requirements create credit crunchesaffecting the real economy?’, the authors argue: “It would in fact be strange if fixed mini-mum capital requirements did not bite in some periods, thereby constraining the banks,given that the purpose of bank [capital] requirements is to limit the amount of risk thatcan be taken relative to capital. However, for this to have an effect on output, itwouldhaveto be true that any shortfall in bank lending was not fully made up through lending byother intermediaries or by access to securities markets.” This statement presupposes thatthe financial intermediation theoryholds. If banks are the creators of themoney supply, andin this role unique and different from non-bank financial intermediaries, as the other twohypotheses maintain, then a reduction in bank credit (creation) must have effects that

2 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

Consequently, many researchers have since been directing theirefforts at incorporating banks or banking sectors in economicmodels.4 This is a positive development, and the European Confer-ences on Banking and the Economy (ECOBATE) are contributing tothis task, showcased in this second special issue, on ECOBATE 2013,held on 6 March 2013 in Winchester Guildhall and organisedby the University of Southampton Centre for Banking, Finance andSustainable Development. As the work in this area remains highly di-verse, this article aims to contribute to a better understanding of crucialfeatures of banks, which would facilitate their suitable incorporation ineconomic models. Researchers need to know which aspects of bankactivity are essential — including important characteristics that maydistinguish banks from non-bank financial institutions. In otherwords, researchers need to know whether banks are unique in crucialaspects, and if so, why.

In this paper the question of their potential ability to createmoney isexamined,which is a candidate for a central distinguishing feature. A re-viewof the literature identifies three different,mutually exclusive viewson thematter, each holding sway for about a third of the twentieth cen-tury. The present conventional view is that banks are mere financial in-termediaries that gather resources and re-allocate them, just like othernon-bank financial institutions, and without any special powers. Anydifferences between banks and non-bank financial institutions areseen as being due to regulation and effectively so minimal that theyare immaterial for modelling or for policy-makers. Thus it is thoughtto be permissible tomodel the economywithout featuring banks direct-ly. This view shall be called the financial intermediation theory of banking.It has been the dominant view since about the late 1960s.

Between approximately the 1930s and the late 1960s, the domi-nant view was that the banking system is ‘unique’, since banks, un-like other financial intermediaries, can collectively create money,based on the fractional reserve or ‘money multiplier’ model ofbanking. Despite their collective power, however, each individualbank is in this view considered to be a mere financial intermediary,gathering deposits and lending these out, without the ability tocreate money. This view shall be called the fractional reserve theoryof banking.

There is a third theory about the functioning of the banking sec-tor, with an ascendancy in the first two decades of the 20th century.Unlike the financial intermediation theory and in line with thefractional reserve theory it maintains that the banking system createsnewmoney. However, it goes further than the latter and differs fromit in a number of respects. It argues that each individual bank is not afinancial intermediary that passes on deposits, or reserves from thecentral bank in its lending, but instead creates the entire loanamount out of nothing. This view shall be called the credit creationtheory of banking.

The three theories are based on a different description of howmoney and banking work and they differ in their policy implications.Intriguingly, the controversy about which theory is correct has neverbeen settled. As a result, confusion reigns: Today we find centralbanks – sometimes the very same central bank – supporting differenttheories; in the case of the Bank of England, central bank staff are on re-cord supporting each one of the threemutually exclusive theories at thesame time, as will be seen below.

It matters which of the three theories is right — not only for un-derstanding and modelling the role of banks correctly within theeconomy, but also for the design of appropriate bank regulationthat aims at sustainable economic growth without crises. Themodern approach to bank regulation, as implemented at least sinceBasel I (1988), is predicated on the understanding that the financial

4 One older attempt that has stood up to the test of time is Werner (1997).

intermediation theory is correct.5 Capital adequacy-based bankregulation, even of the counter-cyclical type, is less likely to deliverfinancial stability, if one of the other two banking hypotheses is cor-rect.6 The capital-adequacy based approach to bank regulationadopted by the BCBS, as seen in Basel I and II, has so far not beensuccessful in preventing major banking crises. If the financial inter-mediation theory is not an accurate description of reality, it wouldthrow doubt on the suitability of Basel III and similar nationalapproaches to bank regulation, such as in the UK.7

It is thus of importance for research and policy to determinewhich ofthe three theories is an accurate description of reality. Empirical evi-dence can be used to test the relativemerits of the theories. Surprisingly,no such test has so far been performed. This is the contribution of thepresent paper.

The remainder of the paper is structured as follows. Section 2provides an overview of relevant literature, differentiating authorsby their adherence to one of the three banking theories. It will beseen that leading economists have gone on the record in supportof each one of the theories. In Section 3, I then present an empiricaltest that is able to settle the question of whether banks are uniqueand whether they can individually create money ‘out of nothing’. Itinvolves the actual processing of a ‘live’ bank loan, taken out by theresearcher from a representative bank that cooperates in the monitor-ing of its internal records and operations, allowing access to its docu-mentation and accounting systems. The results and some implicationsare discussed in Section 4.

2. The literature on whether banks can create money

Much has been written on the role of banks in the economy inthe past century and beyond. Often authors have not been concernedwith the question of whether banks can create money, as they oftensimply assume their preferred theory to be true, without discussing itdirectly, let alone in a comparative fashion. This literature review isrestricted to authors that have contributed directly and explicitly tothe question of whether banks can create credit and money. Duringtime periods when in the authors' countries banks issued promissorynotes (bank notes) that circulated as paper money, writers wouldoften, as a matter of course, mention, even if only in passing, thatbanks create or issue money. In England and Wales, the Bank CharterAct of 1844 forbade banks to “make any engagement for the paymentof money payable to bearer on demand.” This ended bank note issuancefor most banks in England and Wales, leaving the (until 1946 officiallyprivately owned) Bank of England with a monopoly on bank noteissuance. Meanwhile, the practice continued in the United Statesuntil the 20th century (and was in fact expanded with the similarlytimed New York Free Banking Act of 1838), so that US authorswould refer to bank note issuance as evidence of the money creation

non-bank financial intermediaries cannot compensate for.6 See, for instance, Werner (2005, 2010a).7 As seen in the work of the Independent Commission on Banking, ICB, 2011, also

known as the Vickers Commission. For contributions to the consultation of the ICB, see,for instance,Werner (2010b). The recommendations therein, especially the recommenda-tion to discard the financial intermediation theory, were not heeded.

3R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

function of banks until much later.8 For sake of clarity, ourmain interestin this paper is the question whether banks that do not issue banknotes are able to create money and credit out of nothing. As a result,earlier authors, writing mainly about paper money issuance, areonly mentioned in passing here, even if it could be said that their argu-ments might also apply to banks that do not issue bank notes. These in-clude John Law (1705), James Steuart (1767), Adam Smith (1776),Henry Thornton (1802), Thomas Tooke (1838), and Adam Müller(1816), among others, who either directly or indirectly state thatbanks can individually create credit (in line with the credit creationtheory).9

2.1. The credit creation theory of banking

Influential early writers that argue that non-issuing banks have thepower to individually create money and credit out of nothing wrotemainly in English or German, namely Wicksell (1898, 1907), Withers(1909), Schumpeter (1912), Moeller (1925) and Hahn (1920).10 Thereview of proponents of the credit creation theory must start withHenry Dunning Macleod, of Trinity College, Cambridge, and Barristerat Law at the Inner Temple.11 Macleod produced an influential opuson banking, entitled The Theory and Practice of Banking, in two volumes.It was published in numerous editions well into the 20th century(Macleod, 1855–6; the quotes here are from the 6th edition of 1905).Concerning credit creation by individual banks, Macleod unequivocallyargued that individual banks create credit and money out of nothing,whenever they do what is called ‘lending’:

“In modern times private bankers discontinued issuing notes, andmerely created Credits in their customers' favour to be drawnagainst by Cheques. These Credits are in banking language termedDeposits. Now many persons seeing a material Bank Note, which is

8 The practice of issuance of promissory notes by commercial banks has continued forfar longer in Scotland andNorthern Ireland— namely until today. This did not seem, how-ever, to result in a sizeable literature on bank money creation in the UK throughout the20th century.

9 Referring to the issuance of bank notes that circulate as paper money, Smith com-ments “The banks, when their customers apply to them for money, generally advance itto them in their own promissory notes” (p. 242).…“It is chiefly by discounting bills of ex-change, that is, by advancing money upon them before they are due, that the greater partof banks and bankers issue their promissory notes. … The banker, who advances to themerchant whose bill he discounts, not gold and silver, but his own promissory notes,has the advantage of being able to discount to a greater amount by the whole value ofhis promissory notes, which he finds, by experience, are commonly in circulation. He isthereby enabled to make his clear gain of interest on so much a larger sum” (Smith,1776, p. 241). “Jeder Provinzialbanquier strebt dahin, sein Privatgeld zum Nationalgeldezu erheben: er strebt nach der größtmöglichen undmöglichst allgemeinenUmsetzbarkeitseines Privatgeldes. Es ist in England nicht bloß die Regierung, welche Geld macht,sondern die Bank von England, jede Privatbank, ja jede einzelne Haushaltung (ohnegerade bestimmte Noten auszugeben, aber, in wie fern sie sich an eine bestimmte Bankthätig anschließt) helfen das Geld machen” (Müller, 1816, p. 240). “Sobald die Regierungalso die Geldzeichen mechanisch vermehrt, ohne in demselben Maaße jene andernOrgane, denen die Vortheile der Geldvermehrung nur indirekt zu gute kommen, zustärken, ohne um so kräftiger und gerechter das Ganze zu umfassen, so überträgt sie imGrunde nur das Privilegium der Gelderzeugung, das sie im Nahmen des Ganzen ausübt,auf ein einzelnes Organ. … sollte sie [die Regierung] also ihr Privilegium derGelderzeugung nicht bloß aufheben, sondern das bisher erzeugte Geld zurück nehmen,so gibt sie damit nur dem Privatcredit, das heißt, dem verwöhnten verderbtenPrivatcredit, oder dem Wucher die förmliche Befugniß in die Hände, die Lücken zuergänzen, selbst Geldmarken zu machen, und somit seinen verderblichen undvernichtenden Einfluß auf das Ganze nun erst recht zu äußern” (Müller, 1816, p. 305).10 There is also another group of writers who to some extent agreewith this description,but oneway or another downplay its role or importance in practice. In terms of the historyof economic thought it can be said that the latter group laid the groundwork andwere thefounding fathers of the fractional reserve theory. To the extent that they recognise the cre-ation of credit by banks out of nothing under certain circumstances one might argue thatthey could be classified as supporter of either the credit creation theory or the fractional re-serve theory, but tominimise confusion, here the impact their work has had in its commoninterpretation was chosen, as well as their emphasis on reserves as a key mechanism, sothat they were included in the latter theory.11 An Inn of Court with the status of a local authority, inside the territory of the City ofLondon Corporation.

only a Right recorded on paper, arewilling to admit that a BankNoteis cash. But, from the want of a little reflection, they feel a difficultywith regard to what they see as Deposits. They admit that a BankNote is an “Issue”, and “Currency,” but they fail to see that a BankCredit is exactly in the same sense equally an “Issue,” “Currency,”and “Circulation”.”

[Macleod (1905, vol. 2, p. 310)]

“… Sir Robert Peel was quite mistaken in supposing that bankersonly make advances out of bona fide capital. This is so fully setforth in the chapter on the Theory of Banking, that we need onlyto remind our readers that all banking advances are made, inthe first instance, by creating credit” (p. 370, emphasis inoriginal).

In his Theory of Credit Macleod (1891) put it this way:

“A bank is therefore not an office for “borrowing” and “lending”money, but it is a Manufactory of Credit.”

[Macleod (1891: II/2, 594)]

According to the credit creation theory then, banks create credit inthe form of what bankers call ‘deposits’, and this credit is money. Buthow much credit can they create? Wicksell (1907) described a credit-based economy in the Economic Journal, arguing that

“The banks in their lending business are not only not limitedby their own capital; they are not, at least not immediately,limited by any capital whatever; by concentrating in theirhands almost all payments, they themselves create the moneyrequired….”

“In a pure system of credit, where all payments were made by trans-ference in the bank-books, the banks would be able to grant at anymoment any amount of loans at any, however diminutive, rate ofinterest.”12

[Wicksell (1907, 214)]

Withers (1909), from 1916 to 1921 the editor of the Economist, alsosaw few restraints on the amount of money banks could create out ofnothing:

“… it is a common popular mistake, when one is told that the banksof the United Kingdom hold over 900 millions of deposits, to openone's eyes in astonishment at the thought of this huge amount ofcash that has been saved by the community as a whole, and storedby them in the hands of their bankers, and to regard it as a tremen-dous evidence of wealth. But this is not quite the true view of thecase. Most of the money that is stored by the community in thebanks consists of book-keeping credits lent to it by its bankers.”

[Withers (1909, pp. 57 ff.)]

“… The greater part of the banks' deposits is thus seen to consist, notof cash paid in, but of credits borrowed. For every loan makes adeposit….”

[Withers (1909, p. 63)]

“When noteswere the currency of commerce a bankwhichmade anadvance or discounted a bill gave its customer its own notes as theproceeds of the operation, and created a liability for itself. Now, abank makes an advance or discounts a bill, and makes a liability foritself in the corresponding credit in its books.”

[Withers (1909, p. 66)]

12 This paper was read by Wicksell in London in the Economic Section of the British As-sociation in 1906 and it is recorded in the Economic Journal that Palgrave and Edgeworthcommented on it. There is nomentioning of any objections to the claims about the abilityof banks to create money out of nothing.


“… It comes to this that, whenever a bankmakes an advance or buysa security, it gives some one the right to draw a cheque upon it,which cheque will be paid in either to it or to some other banks,and so the volume of banking deposits as a whole will be increasedand the cash resources of the banks as a whole will be unaltered.”

[Withers (1916, p. 45)]

“When once this fact is recognised, that the banks are still, amongother things, manufacturers of currency, just as much as they werein the days when they issued notes, we see how important a func-tion the banks exercise in the economic world, because it is nowgenerally admitted that the volume of currency created has a directand important effect upon prices. This arises fromwhat is called the“quantity theory” of money ….”

[Withers (1916, p. 47)]

“If, then, the quantity theory is, as I believe, broadly true, we see howgreat is the responsibility of the bankers asmanufacturers of curren-cy, seeing that by their action they affect, not only the convenience oftheir customers and the profits of their shareholders, but the generallevel of prices. If banks create currency faster than the rate at whichgoods are being produced, their action will cause a rise in priceswhich will have a perhaps disastrous effect….”13

[Withers (1916, pp. 54 ff.)]

“And so it becomes evident, as before stated, that the deposits of thebanks which give the commercial community the right to drawcheques are chiefly created by the action of the banks themselvesin lending, discounting, and investing” (pp. 71 ff.).

“… then, it thus appears that credit is themachinery bywhich a veryimportant part of modern currency is created …” (p. 72).

Withers argues that the sovereign prerogative to manufacture thecurrency of the nation has effectively been privatised and granted tothe commercial banks:

“By this interesting development the manufacture of currency,which for centuries has been in the hands of Government, has nowpassed, in regard to a very important part of it, into the hands ofcompanies, working for the convenience of their customers andthe profits of their shareholders.”

[Withers (1916, p. 40)]

While Withers was a financial journalist, his writings had a highcirculation and likely contributed to the dissemination of the creditcreation theory in the form proposed by Macleod (1855–6). This view

13 “Since, then, variations in the quantity of currencyhave thesewidespread effects, it is amatter which bankers have to consider seriously, how far it is possible from them to applysome scientific regulation to the volume of currency, and whether it is possible to modifythe evils that follow fromwide fluctuations in prices by some such regulation” (p. 55). Fora more recent application and more precise formulation of this principle, see Werner'sQuantity Theory of Credit (Werner, 1992, 1997, 2005, 2012). “… the most important ofthe modern forms of currency, namely the cheque, is, in effect, manufactured for the useof its customers by banks; and, further, that since the volume of currency has an importanteffect upon raising prices, the extent to which currency is thus created is a responsibilitywhich has to be seriously considered by thosewhowork the financial machine. This man-ufacture of currency is worked through the granting of credit, and credit may thus be de-fined, for the purposes of this inquiry, as the process by which finance makes currency forits customers. Aswe saw in the last chapter, deposits, which are potential currency as theycarry with them the right to draw a cheque, are produced largely through the loans, dis-counts and investments made by bankers” (p. 63). “The creation of credit is thus seenclearly to result in themanufacture of currency whenever the banks buy bills of exchange… or make an advance …. In either case the banks give somebody the right to drawcheques.…When a bankmakes an advance to a stock broker the result is exactly the same…. The same result, in rather a different form, happens when a bank makes investmentson its own account. … There has thus been, in each case, an increase in deposits throughthe operation of the bank in lending, discounting, or investing. If we can imagine all thebanks suddenly selling all their investments and bills of exchange and calling in all theiradvances, the process could only be brought about by the cancelling of deposits, theirown and one another's” (p. 72).

also caught on in Germany with the publication of Schumpeter's(1912, English 1934) influential book The Theory of Economic Develop-ment, in which he was unequivocal in his view that each individualbank has the power to create money out of nothing.

“Something like a certificate of future output or the award ofpurchasing power on the basis of promises of the entrepreneuractually exists. That is the service that the banker performs forthe entrepreneur and to obtain which the entrepreneur ap-proaches the banker.… (The banker) would not be an intermedi-ary, but manufacturer of credit, i.e. he would create himself thepurchasing power that he lends to the entrepreneur…. One couldsay, without committing a major sin, that the banker createsmoney.”14

[Schumpeter (1912, p. 197, emphasis in original)]

“[C]redit is essentially the creation of purchasing power for the pur-pose of transferring it to the entrepreneur, but not simply the trans-fer of existing purchasing power. … By credit, entrepreneurs aregiven access to the social stream of goods before they have acquiredthe normal claim to it. And this function constitutes the keystone ofthe modern credit structure.”

[Schumpeter (1954, p. 107)]

“The fictitious certification of products, which, as it were, the creditmeans of payment originally represented, has become truth.”15

[Schumpeter (1912, p. 223)]

This view was also well represented across the Atlantic, as the writ-ings of Davenport (1913) or Robert H. Howe (1915) indicate. Hawtrey(1919), another leading British economist who like Keynes, had a Trea-sury background andmoved into academia, took a clear stance in favourof the credit creation theory:

“… for the manufacturers and others who have to pay money out,credits are still created by the exchange of obligations, the banker'simmediate obligation being given to his customer in exchange forthe customer's obligation to repay at a future date. We shall still de-scribe this dual operation as the creation of credit. By its means thebanker creates themeans of payment out of nothing, whereas whenhe receives a bag of money from his customer, one means of pay-ment, a bank credit, is merely substituted for another, an equalamount of cash” (p. 20).

Apart from Schumpeter, a number of other German-languageauthors also argued that banks create money and credit individuallythrough the process of lending.16 Highly influential in both academicdiscourse and public debate was Dr. Albert L. Hahn (1920), scion of aFrankfurt banking dynasty (similarly to Thornton who had been abanker) and since 1919 director of the major family-ownedEffecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained law-yer, he became an honorary professor at Goethe-University

14 “Etwas Ähnliches wie eine Bescheinigung künftiger Produkte oder wie die Verleihungvon Zahlkraft an die Versprechungen des Unternehmers gibt es nun wirklich. Das ist derDienst, den der Bankier dem Unternehmer erweist und um den sich der Unternehmeran den Bankier wendet. … so wäre er nicht Zwischenhändler, sondern Produzent vonKredit, d.h. er würde die Kaufkraft, die er dem Unternehmer leiht, selbst schaffen ….Man könnte ohne große Sünde sagen, daß der Bankier Geld schaffe” (S. 197). Translatedby author.15 “Die fiktive Bescheinigung von Produkten, die die Kreditzahlungsmittel sozusagenursprünglich darstellten, ist zur Wahrheit geworden” (Schumpeter, 1912, S. 223). Trans-lated by author.16 For instance, Moeller (1925) states that “In themodernmonetary system the creationof new paper or bank accounting currency (‘Buchungsgeld’, or ‘bank book money’) is pri-marily in the hands of the banks.… For the deposit money the same largely applies as forpaper money…” (pp. 177 ff.).


Frankfurt in 1928. Clearly not only aware of the works of Macleod,whom he cites, but also likely aware of actual banking practicefrom his family business, Hahn argued that banks do indeed ‘createmoney out of nothing’:

“Every credit that is extended in the economy creates a deposit andthus the means to fund it. … The conclusion from the process de-scribed can be expressed in reverse by saying… that every depositthat exists somewhere and somehow in the economy has comeabout by a prior extension of credit.”17

[Hahn (1920, p. 28)]

“We thusmaintain – contrary to the entire literature on banking andcredit – that the primary business of banks is not the liability busi-ness, especially the deposit business, but that in general and in eachand every case an asset transaction of a bank must have previouslytaken place, in order to allow the possibility of a liability businessand to cause it: The liability business of banks is nothing but a reflexof prior credit extension. The opposite view is based on a kind ofoptical illusion ….”18

[Hahn (1920, p. 29)]

Overall, Hahn probably did more than anyone to popularise thecredit creation theory in Germany, his book becoming a bestseller,and spawning much controversy and new research among econo-mists in Germany. It also greatly heightened awareness among jour-nalists and the general public of the topic in the following decades.The broad impact of his book was likely one of the reasons why thistheory remained entrenched in Germany, when it had long beendiscarded in the UK or the US, namely well into the post-war period.Hahn's book was however not just a popular explanation withoutacademic credibility. Schumpeter cited it positively in the second(German) edition of his Theory of Economic Development (Schumpeter,1926), praising it as a further development in line with, but be-yond, his own book. The English translation of Schumpeter's in-fluential book Schumpeter (1912 [1934]) also favourably citesHahn.

It can be said that support for the credit creation theory appears tohave been fairly widespread in the late 19th and early 20th century inEnglish andGerman language academic publications. By 1920, the creditcreation theory had become so widespread that it was dubbed the ‘cur-rent view’, the ‘traditional theory’ or the ‘time-worn theory of bankcredit’ by later critics.19

The early Keynes seemed to also have been a supporter of this dom-inant view. In his Tract on Monetary Reform (Keynes, 1924), he asserts,apparently without feeling the need to establish this further, thatbanks create credit and money, at least in aggregate:

“The internal price level is mainly determined by the amount ofcredit created by the banks, chiefly the Big Five …” (p. 178).

17 “Jeder Kredit der gegebenwird, erzeugt seinerseits einDeposit und damit dieMittel zuseiner Unterbringung. … Die Folgerung aus dem skizzierten Vorgang kann man auchumgekehrt ausrücken, indem man sagt – und dieser Schluß ist ebenso zwingend – , daßjedes irgendwie und irgendwo in der Volkswirtschaft vorhandene Scheck- oderUeberweisungsguthaben sein Entstehen einer vorausgegangenen Kreditgewährung,einem zuvor eingeräumten Kredit zu verdanken hat” (S. 28). Translated by author.18 “Wir behaupten also im Gegensatz zu der gesamten, in dieser Beziehung so gut wieeinigen Bank- und Kreditliteratur, daß nicht das Passivgeschäft der Banken, insbesonderedas Depositengeschäft das Primäre ist, sondern daß allgemein und in jedem einzelnenFalle ein Aktivgeschäft einer Bank vorangegangen sein muß, um erst das Passivgeschäfteiner Bank möglich zu machen und es hervorzurufen: Das Passivgeschäft der Banken istnichts anderes als ein Reflex vorangegangener Kreditgewährung. Die entgegengesetzteAnsicht beruht auf einer Art optischer Täuschung …” (S. 29). Translated by author.19 See, for instance, Phillips (1920, p. 72, p. 119).

“The amount of credit, so created, is in its turn roughly measured bythe volume of the banks' deposits — since variations in this totalmust correspond to the variations in the total of their investments,bill-holdings, and advances” (p. 178).

We know from Keynes' contribution to the Macmillan Committee(1931) that Keynes meant with this that each individual bank wasable to create credit:

“It is not unnatural to think of the deposits of a bank as being createdby the public through the deposit of cash representing either savingsor amounts which are not for the time being required to meet ex-penditure. But the bulk of the deposits arise out of the action of thebanks themselves, for by granting loans, allowing money to bedrawn on an overdraft or purchasing securities a bank creates acredit in its books, which is the equivalent of a deposit” (p. 34).

Concerning the banking system as a whole, this bank credit anddeposit creation was thought to influence aggregate demand and theformation of prices, as Schumpeter (1912) had argued:

“The volume of bankers' loans is elastic, and so therefore is the massof purchasing power…. The banking system thus forms the vital linkbetween the two aspects of the complex structure with which wehave to deal. For it relates the problems of the price level with theproblems of finance, since the price level is undoubtedly influencedby the mass of purchasing power which the banking system createsand controls, and by the structure of credit which it builds …. Thus,questions relating to the volume of purchasing power and questionsrelating to the distribution of purchasing powerfind a common focusin the banking system” (Macmillan Committee, 1931, pp. 12 ff.).

“… if, finally, the banks pursue an easier credit policy and lendmorefreely to the business community, forces are set inmotion increasingprofits and wages, and therefore the possibility of additional spend-ing arises” (p. 13).

Concerning the question whether credit demand or credit supply ismore important, the report argued that the root cause is themovementof the supply of credit:

“The expansion or contraction of the amount of credit made avail-able by the banking system in other directionswill, through a varietyof channels, affect the ease of embarking on new investment propo-sitions. This, in turn, will affect the volume and profitableness ofbusiness, and hence react in due course on the amount of accommo-dation required by industry from the banking system.… Thus whatstarted as an alteration in the supply of credit ends up in the guise ofan alteration in the demand for credit” (p. 99).20

While money is thus seen as endogenous to credit, when what iscalled a ‘bank loan’ is extended, the Committee argued that bank creditwas exogenous as far as loan applicants are concerned:

“There can be no doubt as to the power of the banking system… toincrease or decrease the volume of bank money” (p. 102).

“In normal conditions we see no reason to doubt the capacity of thebanking system to influence the volume of active investment by

20 This is in line with the credit supply determination view proposed byWerner (1997,2005) and his Quantity Theory of Credit, as opposed to the endogenous credit supply viewof many post-Keynesians.

22 It should be noted here that Phillips' (1920) work can be interpreted in a more differ-entiated manner. For instance, Phillips did also point out that if all banks increased theirlending at roughly the same pace, each bankwould, after all, be able to create credit with-out losing reserves or cash, on balance (pp. 78 ff.). However, subsequent writers citingPhillips usually do not mention this. While a more detailed discussion of Phillips is, how-


increasing the volume and reducing the cost of bank credit. … Thuswe consider that in any ordinary times the power of the bankingsystem… to increase or diminish the active employment of moneyin enterprise and investment is indisputable” (p. 102).

TheMacmillan Committee also argued that bank credit could bema-nipulated by the Bank of England, and thus was also considered exoge-nous in this sense.

The credit creation theory remained influential until the early post-war years. The links of credit creation to macroeconomic and financialvariables were later formalised in the Quantity Theory of Credit(Werner, 1992, 1997, 2005, 2012), which argues that credit for (a) pro-ductive use in the form of investments for the production of goods andservices is sustainable and non-inflationary, as well as less likely to be-come a non-performing loan, (b) unproductive use in the form of con-sumption results in consumer price inflation and (c) unproductive usein the form of asset transactions results in asset inflation and, if largeenough, banking crises. However, since the 1920s serious doubts hadspread about the veracity of the credit creation theory of banking. Thesedoubts were initially uttered by economists who in principle supportedthe theory, but downplayed its significance. It is this group of writersthat served as a stepping stone to the formulation of the modern frac-tional reserve theory, which in its most widespread (and later) versionhowever argues that individual banks cannot create credit, but onlythe banking system in aggregate. It is this theory about banks that wenow turn to.

2.2. The fractional reserve theory

An early proponent of the fractional reserve theory was AlfredMarshall (1888). He testified to a government committee about therole of banks as follows:

“I should consider what part of its deposits a bank could lend andthen I should consider what part of its loans would be redepositedwith it and with other banks and, vice versa, what part of the loansmade by other banks would be received by it as deposits. Thus Ishould get a geometrical progression; the effect being that if eachbank could lend two thirds of its deposits, the total amount of loan-ing power got by the banks would amount to three times what itotherwise would be.”

[Marshall (1888), as quoted by Yohe (1995, p. 530)]

With this, he contradicted Macleod's arguments. However,Marshall's view was still a minority view at the time. After the end ofthe First World War, a number of influential economists argued thatthe ‘Old Theory’ (Phillips, 1920:72) of bank credit creation by individualbanks was mistaken. Their view gradually became more influential.“The theory of deposit expansion reached its zenithwith the publicationof C.A. Phillips' Bank Credit …” (Goodfriend, 1991, as quoted by Yohe,1995, p. 532).

Phillips (1920) argued that it was important to distinguish betweenthe theoretical possibility of an individual bank ‘manufacturing money’by lending in excess to cash and reserves on the one hand, and, on theother, the banking system as a whole being able to do this. He arguedthat the ‘Old Theory’ (the credit creation theory) was

“predicated upon the contention that a bank would be able to makeloans to the extent of several times the amount of additional cashnewly acquired and held at the time the loans were made, whereasa representative bank in a system is actually able ordinarily to lendan amount only roughly equal to such cash” (p. 72).21

21 His analysis was based on the “overlooked… pivotal fact that an addition to the usualvolume of a bank's loans tends to result in a loss of reserve for that bank only somewhat lesson average than the amount of the additional loans.…Manifold loans are not extended byan individual bank on the basis of a given amount of reserve” (Phillips, 1920, p. 73).

According to Phillips (1920), individual banks cannot create credit ormoney, but collectively the banking system does so, as a new reserve is“split into small fragments, becomes dispersed among the banks of thesystem. Through the process of dispersion, it comes to constitute thebasis of a manifold loan expansion” (p. 40). Each bank is consideredmainly a financial intermediary: “… the banker … handles chiefly thefunds of others” (pp. 4–5). Phillips argued that since banks targetparticular cash to deposit and reserve to deposit ratios (as cited inthe money multiplier), which they wish to maintain, each bank ef-fectively works as an intermediary, lending out as much as it isable to gather in new cash. Through the process of dispersion andre-iteration, the financial intermediation function of individualbanks, without the power to create credit, adds up to an expansionin the money supply in aggregate.22

Crick (1927) shared this conclusion (with some minor caveats).Thus he argued:

“The important point, which is responsible for much of the contro-versy and most of the misunderstanding, is that while one bank re-ceiving an addition to its cash cannot forthwith undertake a fullmultiple addition to its own deposits, yet the cumulative effect ofthe additional cash is to produce a full multiple addition to the de-posits of all the banks as a whole” (p. 196).

“Summing up, then, it is clear… that the banks, so long as theymain-tain steady ratios of cash to deposits, are merely passive agents of theBank of England policy, as far as the volume of money in the form ofcredit is concerned. … The banks … have very little scope for policyin the matter of expansion or contraction of deposits, though theyhave in the matter of disposition of resources between loans, invest-ments and other assets. But this is not to say that the banks cannotand do not effect multiple additions to or subtractions from depositsas awhole on the basis of an expansion of or contraction in bank cash”(p. 201).

The role of banks remained disputed during the 1920s and 1930s,as several writers criticised the credit creation theory. Views not onlydiverged, but were also in a flux, as several experts apparentlyshifted their position gradually — overall an increasing numbermoving away from the credit creation theory and towards the frac-tional reserve theory.

Sir Josiah C. Stamp, a former director of the Bank of England,summarised the state of debate in his review of an article by Pigou(1927):

“The general public economic mind is in a fair state of muddlementat the present moment on the apparently simple question: “Canthe banks create credit, and if so, how, and how much?” and be-tween the teachings of Dr. Leaf and Mr. McKenna, Messrs. Keynes,Hawtrey, Cassel and Cannan andGregory, people have not yet foundtheir way.”

[Stamp (1927, p. 424)]

ever, beyond the scope of this paper, it is heremerely claimed that Phillips' argument wasan important stepping stone towards the formulation of the fractional reserve theory ofbanking, which is unequivocal in treating individual banks as mere financial intermedi-aries without the power to create credit or money individually under any and all circum-stances, even though it could possibly be argued that Phillips himself may not have agreedwith the latter in all respects.

25 Even though a closer reading of Alhadeff (1954) shows that the author agreed that,under certain circumstances, banks can create credit andmoney: “In certain cases, the pro-portion between the legal reserve ratio and residual deposits is such that even a single


Contributions to this debate were also made by Dennis Robertson(1926), who was influenced by Keynes.23 Keynes (1930) explains therole of reserve holdings and the mechanics of determining a bank's be-haviour based on its preference to hold cash and reserves, together withthe amount of reserves provided by the central bank — the fairlypredeterminedmechanics postulated by themoneymultiplier in a frac-tional reserve model:

“Thus in countrieswhere the percentage of reserves to deposits is bylaw or custom somewhat rigid, we are thrown back for the final de-termination of M, the Volume of Bank-money on the factors whichdetermine the amount of these reserves” (p. 77).

Keynes (1930) also backed a key component of the fractional reservetheory, namely that banks gather deposits and place parts of them withthe central bank, or, alternatively, may withdraw funds from their re-serves at the central bank in order to lend these out to the non-banking sector of the economy:

“When a bank has a balance at the Bank of England in excess of itsusual requirements, it can make an additional loan to the tradingand manufacturing world, and this additional loan creates an addi-tional deposit (to the credit of the borrower or to the credit of thoseto whom he may choose to transfer it) on the other side of thebalance sheet of this or some other bank.”

[Keynes (1930, vol. 2, p. 218)]

Keynes here argues that new deposits, based on new loans, are de-pendent upon and connected to banks' reserve balances held at the cen-tral bank. This view is sometimes also supported by present-day centralbankers, such as in Paul Tucker's or the ECB's proposal to introduce neg-ative interest rates on banks' reserve holdings at the central bank, as anincentive for them to ‘move’ their money from the central bank and in-crease lending.24 Nevertheless, part of Keynes (1930), and much of hismost influential work, his General Theory (1936), appears more in linewith the financial intermediation theory, as will be discussed in the fol-lowing section.

A representative example of the fractional reserve theory that at thesame time was beginning to point in the direction of the financialintermediation theory is the work by Lutz (1939), who published inEconomica, a forum for some of these debates at the time:

“The expansion of the economic system leads to an increase in thevolume of deposits to a figure far in excess of the amount of the ad-ditional cash in use, simply because the same cash is deposited withthe banking system over and over again. … The fact that bankingstatistics show an aggregate of deposits far above the amount of cashin the banking system, is therefore not of itself a sign that the banksmust have created the whole of the difference. This conclusion isalso, of course, somehow implicit in the “multiple expansion” theoryof the creation of bank deposits (of the Phillips or Crick variety). Thattheory explains the creation of deposits by the fact that the samecash (in decreasing amounts) is successively paid into differentbanks. It does, however, look upon this cash movement rather inthe nature of a technical affair between banks … which woulddisappear if the separate banks were merged into one. In that casethe depositswould be regarded as coming into existence by outrightcreation. In our example we assume throughout only one bank, andstill the deposits grow out of the return, again and again, of the same

23 In the Introduction, Robertson says: “I have had so many discussions with Mr. J. M.Keynes on the subject matter of chapters V and VI, and have rewritten them so drasticallyat his suggestion, that I think neither of us now knows how much of the ideas thereincontained is his, and how much is mine (p. 5).” (As cited in Keynes, 1930.)24 On Paul Tucker's proposal, see BBC (2013), and also the critique by Werner (2013a).Negative rates on bank reserves at the central bankwere actually imposed by the Swedishcentral bank in 2009, the Danish central bank in 2012 and for the first time by the Swisscentral bank in 1978 on deposits by foreign banks.

cash by the public.… The force which really creates expansion is thetrade credit given by producers to one another.… The bankplays therole of a mere intermediary.”

… This seems to lead not to a new, but to a very old theory of the func-tion of banks: the function of a mere intermediary… (pp. 166 ff.).

“The modern idea of banks being able to create deposits seemed tobe a startling departure from the view held by most economists inthe nineteenth century. If, however, we approach this modern ideaalong the lines followed above, we find that it resolves itself intomuch the same elements as those which many of the older writersregarded as the essence of banking operations: the provision of con-fidence which induces the economic subjects to extend credit toeach other by using the bank as an intermediary” (p. 169).

Phillips' influence has indeed been significant. Even in 1995Goodfriend still argued that

“… Phillips showed that the summation of the loan- and deposit-creation series across all individual banks yields the multiple expan-sion formulas for the system as a whole. Phillips' definitive expositionessentially established the theory once and for all in the form found ineconomics textbooks today.”

[as reprinted in Yohe (1995, p. 535)]

Statements like this became the mainstream view in the 1950s and1960s.25 The view of the fractional reserve theory in time also came todominate textbook descriptions of the functioning of the monetaryand banking system. There is no post-war textbookmore representativeand influential than that of Samuelson (1948). The original first editionis clear in its description of the fractional reserve theory: Under the head-ing “Can banks really create money?”, Samuelson first dismisses “falseexplanations still in wide circulation” (p. 324):

“According to these false explanations, the managers of an ordinarybank are able, by someuse of their fountain pens, to lend several dol-lars for each dollar left on deposit with them. No wonder practicalbankers see redwhen such behavior is attributed to them. They onlywish they could do so. As every banker well knows, he cannot investmoney that he does not have; and any money that he does invest inbuying a security or making a loanwill soon leave his bank” (p. 324).

Samuelson thus argues that a bank needs to gather the fundsfirst, be-fore it can extend bank loans. This is not consistent with the creditcreation theory. However, Samuelson argues that, in aggregate, the bank-ing system creates money. He illustrates his argument with the exampleof a ‘small bank’ that faces a 20% reserve requirement, and consideringthe accounts of the bank (B/S). If this bank receives a new cash depositof $1000, “What can the bank now do?”, Samuelson asks (p. 325).

“Can it expand its loans and investments by $4000 …?”

“The answer is definitely ‘no’. Why not? Total assets equal totalliabilities. Cash reserves meet the legal requirement of being 20

bank can expand its deposits to a somewhat greater amount than its primary deposits.… Again, it might be possible for a very large bank, or a bank in an isolated communitywith few business connections with outside banks, literally to create money because offlow back deposits. [Footnote: ‘Flow-back deposits refer to the circulation of depositsamong the depositors of the same bank.’] In either case, this amounts to a partial reductionin the average cost of producing credit (making loans), at least in terms of the rawmaterialcosts…” (Alhadeff, 1954, p. 7). Although Alhadeff, if studied closely, could be said to haveagreed that an individual bank can create credit out of nothing, he clearly thought this tobe a special case without practical relevance, while it is normally only the banking systemin aggregate that creates credit.

Fig. 1. The fractional reserve theory as represented in many textbooks.


per cent of total deposits. True enough. But how does the bank payfor the investments or earning assets that it buys? Like everyone elseit writes out a check — to the man who sells the bond or signs thepromissory note. … The borrower spends the money on labor, onmaterials, or perhaps on an automobile. The money will very soon,therefore, have to be paid out of the bank. … A bank cannot eat itscake and have it too. Table 4b gives, therefore a completely false pic-ture of what an individual bank can do” (pp. 325 ff.).

Instead, Samuelson explains, since all the money lent out will leavethe bank, an individual bank cannot create credit out of nothing:

“As far as this first bank is concerned, we are through. Its legal re-serves are just enough to match its deposits. There is nothing moreit can do until the public decides to bring in some more money ondeposit” (p. 326).

On the other hand, Samuelson emphasises that

“The banking systemas awhole can dowhat each small bank cannotdo!” (p. 324),

namely createmoney. This, Samuelson explains via the iterative processof one bank's loans (based on prior deposits) becoming another bank'sdeposits, and so forth. He shows “this chain of deposit creation” in a ta-ble, amounting to total deposits in the banking system of $5000 (out ofthe $1000), due to the reserve requirement of 20% implying a ‘moneymultiplier’ of 5 times (assuming no cash ‘leakage’).

What Samuelson calls the “multiple deposit expansion” is describedin the same way and with remarkable similarity in the fifteenth editionof his book (Samuelson &Nordhaus, 1995) half a century later, only thatthe reserve requirement cited as example has been lowered to 10%: “Allbanks can dowhat one can't do alone” (p. 493). There are subtle thoughimportant differences. The overall space devoted to this topic is muchsmaller in 1995 compared to 1948. The modern textbook says that thecentral bank-created reserves are used by the banks “as an input” andthen “transformed” “into a much larger amount of bank money”(p. 490). There is far less of an attempt to deal with the credit creationtheory. Instead, each bank is unambiguously represented as a pure fi-nancial intermediary, collecting deposits and lending out this money(minus the reserve requirement).26 The fractional reserve theory had be-come mainstream:

“Each small bank is limited in its ability to expand its loans and in-vestments. It cannot lend or invest more than it has received fromdepositors” (p. 496).

Meanwhile, bank deposit money is “supplied” by “the financial sys-tem” in an abstract process that each individual bank has little controlover (p. 494). The unambiguous fractional reserve theory thus appearsto have come about in the years after the 1950s. It can be described inFig. 1.

In this scheme, funds move between the public, the banks and thecentral bankwithout any barriers. Each bank is a financial intermediary,but in aggregate, due to fractional reserve banking, money is created(multiplied) in the banking system. Specifically, each bank can onlygrant a loan if it has previously received new reserves, of which a frac-tion will always be deposited with the central bank. It will then onlybe able to lend out as much as these excess reserves, as is made clearin major textbooks. In the words of Stiglitz (1997):

26 Moreover, the original Samuelson (1948: 331) offered an important (even though notprominently displayed) section headed ‘Simultaneous expansion or contraction by allbanks’, which provided the caveat that each individual bank could, after all, create de-posits, if only all banks did the same at the same rate (thus outflows being on balance can-celled by inflows, as Alhadeff, 1954, also mentioned). There is no such reference in themodern, ‘up-to-date’ textbook.

“It should be clear that when there are many banks, no individualbank can create multiple deposits. Individual banks may not evenbe aware of the role they play in the process of multiple-deposit cre-ation. All they see is that their deposits have increased and thereforethey are able to make more loans” (p. 737).

In another textbook on money and banking:

“In this example, a person went into bank 1 and deposited a$100,000 check drawn on another bank. That $100,000 became partof the reserves of bank 1. Because that deposit immediately createdexcess reserves, further loans were possible for bank 1. Bank 1 lentthe excess reserves to earn interest. A bank will not lend more thanits excess reserves because, by law, it must hold a certain amount ofrequired reserves.”

[Miller and VanHoose (1993, p. 331)]

The deposit of a cheque from another bank does not howeverincrease the “total amounts of deposits and money”:

“Remember, though, that the deposit was a check written onanother bank. Therefore, the other bank suffered a decline in itstransactions deposits and its reserves. While total assets andliabilities in bank 1 have increased by $100,000, they have de-creased in the other bank by $100,000. Thus the total amount ofmoney and credit in the economy is unaffected by the transfer offunds from one depository institution to another. Each depositoryinstitution can create loans (and deposits) only to the extent thatit has excess reserves. The thing to remember is that new reservesare not created when checks written on one bank are deposited inanother bank. The Federal Reserve System, however, can createnew reserves” (p. 331).

The textbook by Heffernan (1996) says:

“To summarise, all modern banks act as intermediaries betweenborrowers and lenders, but they may do so in a variety of differ-ent ways, from the traditional function of taking deposits andlending a percentage of these deposits, to fee-based financialservices” (p. 18).

“For the bank, which pools these surplus funds, there is an opportu-nity for profit through fractional reserve lending, that is, lending out


money at an interest rate which is higher than what the bank payson the deposit, after allowing for the riskiness of the loan and thecost of intermediation” (p. 20).

While the fractional reserve theory succeeded in attracting manyfollowers, rendering it an important and influential theory until thisday, it is not famous for its clarity:

“The problem of the manner in which the banking system increasesthe total volume of the circulating medium, while at the same timethe lending power of the individual banks is severely limited, hasproved to be one of themost baffling forwriters on banking theory.”

[Mints (1945, p. 39)]

Several attempts were made to resolve this within the fractionalreserve theory of banking, such as that by Saving (1977), who renderedthe supply of bank deposits a function of the behaviour of the savers —arguing that the money supply is endogenous. This effectively pushedout the intermediary function from the individual bank level to theeconomy level, and helped ushering in the formulation of the financialintermediation theory to which we now turn.

2.3. The financial intermediation theory

While the fractional reserve theory of banking was influential fromthe 1930s to the 1960s, Keynes may have sown important seeds ofdoubt. Already in his ‘Treatise’, Keynes (1930) makes use of invertedcommas in order to refer, suggestively, to ‘The “Creation” of Bank-Money’ (a section title). This rhetorical device, employed by the expertalready hailed as the leading economist in the world, implied disap-proval, as well as mockery of the concept that banks could createmoney out of nothing. The device was copied by many other writersafter Keynes who also emphasised the role of banks as ‘financialintermediaries’. In Keynes' words:

“A banker is in possession of resources which he can lend or investequal to a large proportion (nearly 90%) of the deposits standing tothe credit of his depositors. In so far as his deposits are Savings-deposits, he is acting merely as an intermediary for the transfer ofloan-capital. In so far as they are Cash-deposits, he is acting both asa provider of money for his depositors, and also as a provider of re-sources for his borrowing-customers. Thus the modern banker per-forms two distinct sets of services. He supplies a substitute forState Money by acting as a clearing-house and transferring currentpayments backwards and forwards between his different customersbymeans of book-entries on the credit and debit sides. But he is alsoacting as a middleman in respect of a particular type of lending,receiving deposits from the public which he employs in purchasingsecurities, or in making loans to industry and trade mainly to meetdemands for working capital. This duality of function is the clue tomany difficulties in the modern Theory of Money and Credit andthe source of some serious confusions of thought.”

[Keynes (1930, vol. 2, p. 213)]The Keynes of the Treatise seems to say that the two functions of

banks are to either act as financial intermediary fulfilling the utilitybanking function of settling trades, or to act as financial intermediarygathering deposits and lending the majority of these out. There seemsno money creation at all involved, certainly not on the individual banklevel. Keynes' most influential opus, General Theory (Keynes, 1936)quickly eclipsed his earlier Treatise on Money in terms of its influenceon public debate. In the General Theory, Keynes did not place any em-phasis on banks, which he now argued were financial intermediariesthat needed to acquire deposits before they could lend:

“The notion that the creation of credit by the banking system allowsinvestment to take place to which ‘no genuine saving’ corresponds

can only be the result of isolating one of the consequences of the in-creased bank-credit to the exclusion of the others.… It is impossiblethat the intention of the entrepreneur who has borrowed in order toincrease investment can become effective (except in substitution forinvestment by other entrepreneurs which would have occurredotherwise) at a faster rate than the public decide to increase theirsavings. … No one can be compelled to own the additional moneycorresponding to the new bank-credit, unless he deliberately prefersto hold moremoney rather than some other form of wealth.… Thusthe old-fashioned view that saving always involves investment,though incomplete and misleading, is formally sounder than thenewfangled view that there can be savingwithout investment or in-vestment without ‘genuine’ saving.”

[Keynes (1936, pp. 82 ff.)]

Schumpeter (1954) commented on this shift in Keynes' view:

The “deposit-creating bank loan and its role in the financing of in-vestment without any previous saving up of the sums thus lent havepractically disappeared in the analytic schemaof the General Theory,where it is again the saving public that holds the scene. OrthodoxKeynesianism has in fact reverted to the old view …. Whether thisspells progress or retrogression, every economist must decide forhimself” (p. 1115, italics in original).

The early post-war period saw unprecedented influence of Keynes'General Theory, and a Keynesian school of thought that managed toignore Keynes' earlier writings on bank credit creation, becamedominant in academia. Given that a former major proponent of boththe credit creation and the fractional reserve theories of banking hadshifted his stance to the new financial intermediation theory, it is notsurprising that others would follow.

A highly influential challenge to the fractional reserve theory ofbanking was staged by Gurley and Shaw (1955, 1960). They rejectedthe view that “banks stand apart in their ability to create loanablefunds out of hand while other intermediaries in contrast are busy withthe modest brokerage function of transmitting loanable funds that aresomehow generated elsewhere” (1955, p. 521). Beyond the usual rhe-torical devices to denigrate the alternative theories, Gurley and Shaw'sactual argumentwas that banks should not be singled out as being ‘spe-cial’, since the banks' financial intermediation function is identical tothat of other financial intermediaries:

“There aremany similarities between themonetary system and non-monetary intermediaries, and the similarities are more importantthan the differences. Both types of financial institutions create finan-cial claims; and both may engage in multiple creation of their partic-ular liabilities in relation to any one class of asset that they hold.”

[Gurley and Shaw (1960, p. 202)]

Banks and the banking system,we are told, like other financial inter-mediaries, need to first gather deposits, and then are able to lend theseout. In this view, any remaining special role of banks is due to outmodedregulations, which treat banks differently. Therefore, they argue, theFederal Reserve should extend its banking supervision to the growingset of non-bank financial intermediaries, thus treating them equally tobanks.

Initial challenges by proponents of the fractional reserve theoryof banking (see Guttentag & Lindsay, 1968) were swept awayduring the 1960s, when James Tobin, a new rising star in economics,took a clear stand to proclaim another ‘new view’ of banking, formulat-ing themodern version of the financial intermediation theory of banking.

“Tobin (1963), standing atop the wreckage in 1963 to set forth the‘new view’ of commercial banking, stands squarely with Gurleyand Shaw against the traditional view.”

[Guttentag and Lindsay (1968, p. 993)]


Like Keynes, Alhadreff and others before him, Tobin only referred tobank credit creation in inverted commas, and used rhetorical devices toridicule the idea that banks, individually or collectively, could createmoney and credit. Tobin (1963) argued:

“Neither individually nor collectively do commercial banks possess awidow's cruse” (p. 412).

“The distinction between commercial banks and other financial inter-mediaries has been too sharply drawn. The differences are of degree,not of kind …. In particular, the differences which do exist have littleintrinsically to do with the monetary nature of bank liabilities … Thedifferences are more importantly related to the special reserve re-quirements and interest rate ceilings to which banks are subject.Any other financial industry subject to the same kind of regulationswould behave in much the same way” (p. 418).

Banks only seem to be different from others, because regulatorserroneously chose to single them out for special regulation. In Tobin'sview, “commercial banks are different, because they are controlled,and not the other way around” (Guttentag & Lindsay, 1968, p. 993).Tobin and Brainard's (1963) portfolio model made no distinction be-tween banks and non-bank financial intermediaries, indeed, ignoredthe role of banks altogether and contributedmuch towards themodernmainstream view of economics models without banks. Branson (1968)further developed Tobin's new approach, which was popular in theleading journals.

Guttentag and Lindsay (1968)wrote in the Journal of Political Economythat despite the challenge by Gurley and Shaw (1955) “The uniquenessissue, on the other hand, remains unsettled” (p. 992). Banks, they argued,are different in their role and impact from non-bank financial intermedi-aries, since “commercial banks have a greater capacity for varying the ag-gregate volume of credit than other financial intermediaries” (p. 991).“These points provide a rationale for special controls on commercialbanks that goes beyond the need to prevent financial panic. It is the ratio-nale that has been sought by defenders of the traditional view that com-mercial banks are ‘unique’ ever since the Gurley–Shaw challenge to thisview” (p. 991).

Undaunted, Tobin (1969) re-states his view in an article estab-lishing his portfolio balance approach to financial markets, which ar-gues that financial markets are complex webs of assets and prices,leaving banks as one of many types of intermediaries, without anyspecial role.27 This was the first article in the first edition of a newjournal, the Journal of Money, Credit and Banking. While its namemay suggest openness towards the various theories of banking, inpractice it has only published articles that did not support the creditcreation theory and weremainly in line with the financial intermediationtheory. This is also true for most other journals classified as ‘leadingjournals’ in economics (for instance, using the 4-rated journals from theUK Association of Business Schools list in economics). Henceforth, theportfolio balance approach, which treated all financial institutions asmere portfolio managers, was to hold sway. It helped the financial

27 The conclusion of Tobin's paper: “According to this approach, the principal way inwhich financial policies and events affect aggregate demand is by changing the valuationsof physical assets relative to their replacement costs. Monetary policies can accomplishsuch changes, but other exogenous events can too. In addition to the exogenous variablesexplicitly listed in the illustrative models, changes can occur, and undoubtedly do, in theportfolio preferences – asset demand functions – of the public, the banks, and other sec-tors. These preferences are based on expectations, estimates of risk, attitudes towards risk,and a host of other factors. In this complex situation, it is not to be expected that the essen-tial impact of monetary policies and other financial events will be easy to measure in theabsence of direct observation of the relevant variables (q in themodels). There is no reasonto think that the impactwill be captured in any single exogenous or intermediate variable,whether it is a monetary stock or a market interest rate” (Tobin, 1969, p. 29).

intermediation theory become the dominant creed among economistsworld-wide.

Modern proponents of the ubiquitous financial intermediation theoryinclude, among others, Klein (1971), Monti (1972), Sealey and Lindley(1977), Diamond and Dybvig (1983), Diamond (1984, 1991, 2007),Eatwell, Milgate, and Newman (1989), Gorton and Pennacchi (1990),Bencivenga and Smith (1991), Bernanke and Gertler (1995), Rajan(1998), Myers and Rajan (1998), Allen and Gale (2000, 2004a,b), Allenand Santomero (2001), Diamond and Rajan (2001), Kashyap, Rajan,and Stein (2002), Hoshi and Kashyap (2004), Matthews andThompson (2005), Casu and Girardone (2006), Dewatripont, Rochetand Tirole (2010), Gertler and Kiyotaki (2011) and Stein (2014). Thereare many more: It is impossible to draw up a conclusive list, since thevast majority of articles published in leading economics and financejournals in the last thirty to forty years is based on the financial interme-diation theory as premise.28

Quoting only a few examples, Klein (1971), Monti (1972) (later tobecome EU commissioner and prime minister of Italy), and othersmodel banks as financial intermediaries, gathering deposits and lendingthese funds out:

“The bank has two primary sources of funds; the equity originallyinvested in the firm … and borrowed funds secured through the is-suance of various types of deposits ….”

[Klein (1971, p. 208)]

“… It will be shown how the bank determines the prices it will payfor various types of deposits and how these prices, in conjunctionwith the deposit supply functions the bank confronts, determinethe scale and composition of the bank's deposit liabilities the bankwill assume.”

[Klein (1971, p. 210)]

Diamond and Dybvig (1983) are cited as the seminal work on bank-ing, and they argue that “Illiquidity of assets provides the rationale bothfor the existence of banks and for their vulnerability to runs” (p. 403).But in actual fact their theory makes no distinction between banksand non-banks. They therefore are unable to explain why we haveheard of bank runs, but not of ‘insurance runs’ or ‘finance companyruns’, although the latter also hold illiquid assets and give out loans.Diamond and Dybvig fail to identify what could render banks specialsince they assume that they are not.

Other theories of banks as financial intermediaries are presented byMayer (1988) and Hellwig (1977, 1991, 2000), who also believe thatbanks are merely financial intermediaries:

“The analysis uses the original model of Diamond (1984) of financialcontracting with intermediation as delegated monitoring.…Monitor-ing is assumed to be too expensive to be used by the many house-holds required to finance a firm or an intermediary. Howeverdirect finance of firms based on nonpecuniary penalties may bedominated by intermediated finance with monitoring of firms byan intermediarywho in turn obtains funds fromhouseholds throughcontracts involving nonpecuniary penalties.”

[Hellwig (2000, pp. 721 ff.)]

Banking expert Heffernan (1996) states:

“The existence of the “traditional” bank, which intermediates be-tween borrower and lender, and which offers a payments serviceto its customers, fits in well with the Coase theory” (p. 21).

28 This also means that the innumerable PhD theses andMasters dissertations producedin this area in the last thirty years or so are mainly based on the financial intermediationtheory. For instance, Wolfe (1997) states: “Banks possess the power of intermediation,which is the ability to transform deposits into loans. Deposits with one set of characteris-tics are transformed into assets with other or different characteristics” (p. 12).


… or a leading textbook on international economics and finance, byKrugman and Obstfeld (2000):

“Banks use depositors' funds to make loans and to purchase otherassets …” (p. 659).

A widely used reference work on banking and money – the NewPalgrave Money (Eatwell et al., 1989) – contains a number of contribu-tions by leading monetary economists and banking experts. In it,Baltensperger (1989) clearly supports the financial intermediation theory:

“The role of credit as such must be clearly separated from the eco-nomic role of credit institutions, such as banks, playing the role ofspecialised intermediaries in the credit market by buying and simul-taneously selling credit instruments (of a different type and quality).Since the ultimate borrowers and lenders can, in principle, dobusiness with each other directly, without the help of such an inter-mediary, the function of these middlemen must be viewed as sepa-rate from that of credit as such. Twomain functions of institutions ofthis kind can be distinguished. The first is the function of risk consol-idation and transformation. … The second major function of theseinstitutions is that of a broker in the credit markets. As such, theyspecialise in producing intertemporal exchange transactions andowe their existence to their ability to bring together creditors anddebtors at lower costs than the latter can achieve in direct transac-tions themselves” (pp. 100 ff.).

Indeed, almost all authors in this reference book refer to banks asmere financial intermediaries, even Goodhart (1989):

“‘Intermediation’ generally refers to the interposition of a financialinstitution in the process of transferring funds between ultimatesavers and ultimate borrowers. … Disintermediation is then said tooccur when some intervention, usually by government agencies forthe purpose of controlling, or regulating, the growth of financial in-termediaries, lessens their advantages in the provision of financialservices, and drives financial transfers and business into otherchannels.… An example of this is to be foundwhen onerous reserverequirements on banks lead them to raise the margin (the spread)between deposit and lending rates, in order tomaintain their profit-ability, so much that themore credit-worthy borrowers are inducedto raise short-term funds directly from savers, for example, in thecommercial paper market” (p. 144).

Myers and Rajan (1998) state:

“Wemodel the intermediary as a bank that borrows from a numberof individual investors for its own core business and to lend on to aproject.… Even though the bank can extractmore from the ultimateborrower, the bank has to finance these loans by borrowing from in-dividual investors” (p. 755).

Allen and Santomero (2001), in their paper entitled ‘What do finan-cial intermediaries do?’ state:

“In this paper we use these observations as a starting point forconsidering what it is that financial intermediaries do. At center, ofcourse, financial systems perform the function of reallocating the re-sources of economic units with surplus funds (savers) to economicunits with funding needs (borrowers)” (p. 272).

Kashyap (2002) also believes that banks are pure financial interme-diaries, not materially distinguishable from other non-bank financialinstitutions.29

Stein (2014) states, albeit with some hesitation:

29 See Werner (2003b) for a detailed critique of Kashyap (2002).

“… at least in some cases, it seems that a bank's size is determined byits deposit franchise, and that, taking these deposits as given, itsproblem then becomes one of how best to invest them” (p. 5).

“Overall, our synthesis of these stylised facts is that banks are in thebusiness of taking deposits and investing these deposits in fixed-income assets that have certain well-defined risk and liquidity attri-butes but which can be either loans or securities” (p. 7).

The financial intermediation theory includes the ‘credit view’ in mac-roeconomics, proposing a ‘bank lending channel’ of monetary transmis-sion (Bernanke & Blinder, 1989; Bernanke & Gertler, 1995), as well asthe neo-classical and new classical macroeconomic models (if theyconsider banks at all). To these and most contemporary authors in eco-nomics and finance, banks are financial intermediaries like other firmsin the financial sector, which focus on the ‘transformation’ of liabilitieswith particular features into assetswith other features (e.g. with respectto maturity, liquidity and quantity/size), or which focus on ‘monitoring’others (Sheard, 1989, another adherent of the financial intermediationtheory of banking), but do not create credit individually or collectively.This is true for many ‘Post-Keynesians’ who argue that the money sup-ply is determined by the demand for money. It is also true for populardescriptions, such as that by Koo and Fujita (1997) who argue thatbanks are merely financial intermediaries:

“But those financial institutions that are counterparties of the Bankof Japan obtain their funding primarily from the money that depos-itors have deposited with them. This money they cannot pass on forconsumption and capital investment, because they have to lend it atinterest to earnmoney. In otherwords, for thismoney to support theeconomy, these financial institutions must lend it to firms and indi-viduals. Those borrowers must then use it to buy assets such asmachinery or housing or services” (p. 31).

A recent paper by Allen, Carletti, and Gale (2014) introducesmoney—albeit only cash created by the central bank, while banks are merefinancial intermediaries that cannot create money or credit.

As a result, the leading forecasting models used by policy makersalso do not include banks (Bank of England, 2014a). Even the originalmeaning of credit creation seems forgotten by the modern literature:Bernanke (1993) uses the expression ‘credit creation’ much in his arti-cle, but explains that this concept is defined as “the process by whichsaving is channeled to alternative uses”, i.e. financial intermediation ofsavers' deposits into loans:

“This fortuitous conjunction of events and ideas has contributed to anenhanced appreciation of the role of credit in the macroeconomy bymost economists and policymakers. The purpose of this paper is to re-view and interpret some recent developments in our understandingof the macroeconomic role of credit or, more accurately, of the creditcreation process. By credit creation process I mean the process bywhich, in exchange for paper claims, the savings of specific individualsor firms are made available for the use of other individuals or firms(for example to make capital investments or simply to consume).Note that I am drawing a strong distinction between credit creation,which is the process by which saving is channeled to alternative uses,and the act of saving itself…. Inmy broad conception of the credit cre-ation process I includemost of the value-added of the financial indus-try, including the information-gathering, screening, and monitoringactivities required to make sound loans or investments, as well asmuch of the risk-sharing, maturity transformation, and liquidity pro-vision services that attract savers and thus support the basic lendingand investment functions. I also want to include in my definition ofthe credit creation process activities undertaken by potential bor-rowers to transmit information about themselves to lenders: for ex-ample, for firms, these activities include provision of data to the


public, internal or external auditing, capital structure decisions, andsome aspects of corporate governance. The efficiency of the credit cre-ation process is reflected both in its ability tominimise the direct costsof extending credit (for example, the aggregate wage bill of the finan-cial industry) and in the degree to which it is able to channel aneconomy's savings into the most productive potential uses. The pre-sumption of traditionalmacroeconomic analysis is that this credit cre-ation process, through which funds are transferred from ultimatesavers to borrowers, works reasonably smoothly and therefore canusually be ignored.”

[Bernanke (1993, pp. 50 ff.)]

As Bernanke points out, those works that assume such a financial in-termediation role for banks will therefore often ignore banks entirely:they cannot be particularly important or relevant in the economy.Many went as far as to leave out any kind of money (there are no mon-etary aggregates in Kiyotaki & Moore, 1997; Woodford, 2003). The mostwidely used textbook in advanced Master-level economics at leadingBritish universities in 2010was Romer (2006). On page 3, Romer tells us:

“Incorporating money in models of [economic] growth would onlyobscure the analysis” (p. 3).

Table 1Account changes due to bank loan (credit creation theory).

2.4. Conclusion of the literature review

Since the 1960s it has become the conventional view not to considerbanks as unique and able to create money, but instead asmere financialintermediaries like other financial firms, in line with the financialintermediation theory of banking. Banks have thus been dropped fromeconomics models, and finance models have not suggested that bankaction has significant macroeconomic effects. The questions of wheremoney comes from and how the money supply is created and allocatedhave remained unaddressed.

The literature review has identified a gradual progression of viewsfrom the credit creation theory to the fractional reserve theory to thepresent-day ubiquitous financial intermediation theory. The develop-ment has not been entirely smooth; several influential writers haveeither changed their views (on occasion several times) or have shiftedbetween the theories. Keynes, as an influential economist, did little toenhance clarity in this debate, as it is possible to cite him in support ofeach of the three hypotheses, through which he seems to have movedsequentially.30 Some institutions, such as the Bank of England, manageto issue statements in support of all three theories.

We conclude from the literature survey that all three theories ofbanking have been well represented in the course of the 20th century,by leading figures of the day. However, the conclusion by Sir JosiahStamp (1927), a director at the Bank of England, still seems to holdtoday, namely that there is “a fair state of muddlement… on the appar-ently simple question: ‘Can the banks create credit, and if so, how, andhow much?’” Despite a century or so of theorising on the matter,there has been little progress in establishing facts unambiguously.Thus today the conclusion of 1968 applies, namely that the issue cannotbe considered as ‘settled’. It is possible that the pendulum is about toswing away from the financial intermediation theory to one of theother two. But how can we avoid that history will merely repeat itselfand the profession will spend another century locked into a debatewithout firm conclusion?

How can the issue be settled and the ‘muddlement’ cleared up? Onereason for this “state of muddlement” is likely to be the methodologydominant in 20th century economics, namely the hypothetico-deductivemethod. Unproven ‘axioms’ are ‘posed’ andunrealistic assump-tions added, to build a theoretical model. This can be done for all threetheories, and we would be none the wiser about which of them actually

30 Thoughwith the caveat that several of his statements, made at the same time, seem tosupport different theories of banking.

applied. How can the issue be settled? The only way the facts can beestablished is to leave theworld of deductive theoreticalmodels and con-sider empirical reality as the arbiter of truth, in line with the inductivemethodology. In other words, it is to empirical evidence we must turnto settle the issue.

3. The empirical test

The simplest possible test design is to examine a bank's internalaccounting during the process of granting a bank loan. When all the nec-essary bank credit procedures have been undertaken (starting from‘know-your-customer’ and anti-money laundering regulations to creditanalysis, risk rating to the negotiation of the details of the loan contract)and signatures are exchanged on the bank loan, the borrower's currentaccount will be credited with the amount of the loan. The key questionis whether as a prerequisite of this accounting operation of booking theborrower's loan principal into their bank account the bank actually with-draws this amount fromanother account, resulting in a reduction of equalvalue in the balance of another entity— either drawing down reserves (asthe fractional reserve theorymaintains) or other funds (as the financial in-termediation theorymaintains). Should it be found that the bank is able tocredit the borrower's account with the loan principal without havingwithdrawn money from any other internal or external account, or with-out transferring themoney fromany other source internally or externally,this would constitute prima facie evidence that the bank was able to cre-ate the loan principal out of nothing. In that case, the credit creation the-orywould be supported and the theory that the individual bank acts as anintermediary that needs to obtain savings or funds first, before being ableto extend credit (whether in conformity with the fractional reserve theoryor the financial intermediation theory), would be rejected.

3.1. Expected results

With a bank loan of €200,000, drawn by the researcher from a bank,the following changes in the lending bank's accounting entries areexpected a priori according to each theory:

(a) Bank credit accounting according to the credit creation theory.According to this theory, banks behave very differently fromfinan-cial intermediaries, such as stock brokers, since they do not sepa-rate customer funds from own funds. Money ‘deposited’ with abank becomes the legal property of the bank and the ‘depositor’is actually a lender to the bank, ranking among the general credi-tors. When extending bank credit, banks create an imaginary de-posit, by recording the loan amount in the borrower's account,although no new deposit has taken place (credit creation out ofnothing). The balance sheet lengthens. Cash, central bank reservesor balances with other banks are not immediately needed, as re-serve and capital requirements only need to be met at particularmeasurement intervals. The account changes are shown in Table 1.

(b) Bank credit accounting according to the fractional reserve theory.The distinguishing feature of this theory is that each individualbank cannot create credit out of nothing. The bank is afinancial intermediary indistinguishable fromotherfinancial inter-mediaries, such as stock brokers and securities firms. However,banks are said to be different in one respect, namely the regulatorytreatment: regulators have placed onerous rules concerning re-serves that have to be held with the central bank only on banks,not other financial intermediaries. A bank can only lend money,

Unlabelled image

Table 3Account changes due to bank loan (fin. intermediation theory).


when it has previously received the same amount in excess re-serves from another bank, whose own reserve balances will havedeclined, or from the central bank (Table 2).

Table 2Account changes due to bank loan (fractional reserve theory).

Step 1. Precondition for the bank loan

Step 2. The bank loan

“A bank will not lend more than its excess reserves because, by law,itmust hold a certain amount of required reserves.… Each deposito-ry institution can create loans (and deposits) only to the extent thatit has excess reserves.”

[Miller and VanHoose (1993, p. 331)]

Following the exposition in Miller and VanHoose (1993, pp.330–331), the balance sheet evolution in case of a €200,000 loan is asshown in Table 2.

In other words, for the bank to be able to make a loan, it first has tocheck its excess reserves, as this is, according to this theory, a strictlybinding requirement and limitation, aswell as its distinguishing feature.The bank cannot at any moment lend more money than its excess re-serves, and it will have to draw down the reserve balance to lend. (Thus,as noted, another distinguishing feature is that the balance sheet expan-sion is driven by the prior increase in a deposit that boosted excess re-serves, not by the granting of a loan).

It needs to be verified when the empirical test of bank lending is im-plemented, whether the bank first confirmed the precise amount of itsavailable excess reserves before entering into the loan contract or payingout the loan funds to the customer, so as not to exceed that figure. If thebank is found not to have checked or not to have drawn down its reservebalances then this constitutes a rejection of the fractional reserve theory.

(c) Bank credit accounting according to the financial intermediationtheory.According to this theory, banks are, as far as payments and ac-counts are concerned, not different from non-bank financial insti-tutions. The reserve requirement is not an issue — a claimsupported by the empirical observation that reserve requirementshave been abolished in a number of major economies, such as theUKand Swedenmany years ago. However, UKfinancial intermedi-aries are required by FSA/FCA-administered Client Money rules tohold deposits in custody for customers (a form of warehousing,the deposits legally being bailments). Client funds of financial in-termediaries, such as securities firms, stock brokers and the likeare therefore still owned by the depositors and thus kept separate-ly from the financial institutions' own funds, so that customer de-posits are not shown on the balance sheet as liabilities. If banks aremerely financial intermediaries, indistinguishable from other in-termediaries, then all bank funds are central bank money thatcan be held in reserve at the central bank or deposited withother banks. The balance sheet implications are shown belowin Table 3.

According to this theory, the bank balance sheet does not lengthenas a result of the bank loan: the funds for the loan are drawn from thebank's reserve account at the central bank.

3.2. A live empirical test

The design of the empirical test takes the form of a researcher enter-ing into a live loan contract with the bank, and the bank extending aloan, while its relevant internal accounting is disclosed. Several banksin the UK and Germany were approached and asked to cooperate inan academic study of bank loan operations.

The large banks declined to cooperate. The reason given was usuallytwofold: the required disclosure of internal accounting data and proce-dures would breach their confidentiality or IT security rules; secondly,the transactions volumes of the banks were so large that the plannedtest would be very difficult to conduct when borrowing sensibly sizedamounts of money that would not clash with the banks' internal riskmanagement rules. In that case, any single transaction would not beeasy to isolate within the bank's IT systems. Despite various discussionswith a number of banks, in the end the banks declined on the basis ofthe above reasons and additionally that the costs of operating their sys-tems and controlling for any potential other transactions would beprohibitive.

It was therefore decided to approach smaller banks, of which thereare many in Germany (there are approximately 1700 local, mostlysmall banks in Germany). Each owns a full banking license and engagesin universal banking, offering allmajor banking services, including stocktrading and currencies, to the general public. A local bankwith a balancesheet of approximately €3 billion was approached, as well as a bankwith a balance sheet of about €700 million. Both declined on the samegrounds as the larger banks, but one suggested that a much smallerbank might be able to oblige, pointing out the advantage that therewould be fewer transactions booked during the day, allowing a cleareridentification of the empirical test transaction. At the same time the em-pirical information value would not diminish with bank size, since allbanks in the EU conform to identical European bank regulations.

Thus an introduction to RaiffeisenbankWildenberg e.G., located in asmall town in the district of Lower Bavaria was made. The bank is a co-operative bank within the Raiffeisen and cooperative bankingassociation of banks, with eight full-time staff. The two joint directors,Mr. Michael Betzenbichler and Mr. Marco Rebl both agreed to the em-pirical examination and also to share all available internal accountingrecords and documentation on their procedures. A written agreementwas signed that confirmed that the planned transactions would bepart of a scientific empirical test, and the researcher would not abscondwith the funds when they would be transferred to his personal account,and undertakes to immediately repay the loan upon completion of thetest (Supplementary material 1 in online Appendix 3). One limitationon the accounting records which is common to most banks is thatthey are outsourcing the IT to a specialised bank IT company, whichmaintains its own rules concerning data protection and confidentiality.

The IT firm serves the majority of the 1,100 cooperative banks inGermany, using the same software and internal systems and accountingrules, ensuring that the test is representative of more than 15% of bankdeposits in Germany.

It was agreed that the researcherwould personally borrow €200,000from the bank. The transactionwas undertaken on 7 August 2013 in theoffices of the bank in Wildenberg in Bavaria. Apart from the two (sole)directors, also the head (and sole staff) of the credit department,Mr. Ludwig Keil was present. The directors were bystanders not engag-ing in any action. Mr. Keil was the only bank representative involved inprocessing the loan from the start of the customer documentation, to

Table 4The empirical researcher's new bank account.Bank: RaiffeisenbankWildenberg e.G.Customer: Richard Werner.Date: 7 August 2013.

Account no. Type of product Currency A/C balance

Current account44636 Current account w/o fees EUR 200,000.00

Total in EUR: 200,000.00

Loan20044636 Other private financing EUR −200,000.00

Total in EUR: −200,000.00

Table 5


the signing of the loan contract and finally paying out the loan into theborrower's account. The entire transaction, including themanual entriesmade by Mr. Keil, was filmed. The screens of the bank's internal IT ter-minal were also photographed. Moreover, a team from the BBC waspresent and filmed the central part of the empirical bank creditexperiment (Reporter Alistair Fee and a cameraman).

The bank disclosed their standard internal credit procedure. The se-quence of the key steps is shown in Appendix 1. As can be seen, the lasttwo steps are the signing of the ‘credit documents’ by the borrower(the researcher) and,finally, the payment of the loan at the value date.31

The loan conditions were agreed: the researcher would borrow EUR200,000 from the bank at the prime rate (the interest rate for the bestcustomer). In the event the bank waived the actual interest proceeds,in support of the scientific research project.

When the bank loan contract was signed by both the bank and theborrower on 7 August 2013, the loan amountwas immediately creditedto the borrower's account with the bank, as agreed in the loan contract.Supplementary material 2 in online Appendix 2 shows the originalborrower's accounts and balances with Raiffeisenbank Wildenberg.The key information from the account summary table is repeatedhere, in English, in Table 4.

The bank also issued the following accounts overview, which is astandard T-account of the transaction from the borrower's perspective(Table 5).

The borrower confirmed that his new current accountwith the banknow showed a balance of EUR 200,000 that was available for spending(An extension of the experiment, to be reported on separately, usedthe balance the following day for a particular transaction outside thebanking institution, transferring the funds to another account of the re-searcher, held with another bank; this transfer was duly completed,demonstrating that the funds could be used for actual transactions).

We are now moving to the empirical test of the three bankingtheories. The critical question is: where did Raiffeisenbank Wildenberge.G. obtain the funds from that the borrower (researcher) was creditedwith (and duly used and transferred out of the bank the following day)?When the researcher inquired about the bank's reserve holdings, in linewith the fractional reserve theory of banking, director Marco Rebl ex-plained that the bankmaintained its reserves with the central organisa-tion of cooperative banks,which in turnmaintained an accountwith thecentral bank. These reserves amounted to a fixed amount of €350,000that did not change during the observation period. Concerning thebank credit procedure, the researcher attempted to verify the sourceof the funds that were about to be lent.

Firstly, the researcher confirmed that the only three bank officers in-volved in this test and bank transactionwere present throughout, where-by two (the directors) only watched and neither accessed any computerterminal nor transmitted any instructions whatsoever. The accountsmanager (head of the credit department, Mr. Keil) was the only operatorinvolved in implementing, booking and paying out the loan. His actionswere filmed. It was noted and confirmed that none of the bank staff pres-ent engaged in any additional activity, such as ascertaining the availabledeposits or funds within the bank, or giving instructions to transferfunds from various sources to the borrower's account (for instance bycontacting the bank internal treasury desk and contacting bank externalinterbank funding sources). Neither were instructions given to increase,drawdown or borrow reserves from the central bank, the central cooper-ative bank or indeed any other bank or entity. In other words, it was ap-parent that upon the signing of the loan contract by both parties, thefunds were credited to the borrower's account immediately, without

31 It is of interest that the last step expressly requires the bank staff implementing thiscredit procedure to only pay out the loan for the agreed purpose, as evidence for whicha receipt for any purchases undertaken with the loan funds are demanded by the bank.This demonstrates that the implementation of policies of credit guidance by purpose ofthe loan is practically possible, since such data is available and the use of the loan is mon-itored and enforced by each bank.

any other activity of checking or giving instructions to transfer funds.There were no delays or deliberations or other bookings. The momentthe loanwas implemented, the borrower sawhis current account balanceincrease by the loan amount. The overall credit transaction, from start tofinish, until funds were available in the borrower's account, took about35 min (and was clearly slowed down by the filming and frequent ques-tions by the researcher).

Secondly, the researcher asked the three bank staff present whetherthey had, either before or after signing the loan contract and beforecrediting the borrower's account with the full loan amount inquired ofanyother parties internally or externally, checked the bank's available de-posit balances, or made any bookings or transfers of any kind, in connec-tion to this loan contract. They all confirmed that they did not engage inany such activity. They confirmed that upon signing the loan contract theborrower's account was credited immediately, without any such steps.

Thirdly, the researcher obtained the internal daily account statementsfrom the bank. These are produced only once aday, after close of business.Since the bank is small, it was hoped that it would be possible to identifythe impact of the €200,000 loan transaction, and distinguish the account-ing pattern corresponding to one of the three banking hypotheses.

4. Results

Supplementary material 3 in online Appendix 3 shows the scan ofthe bank's balance sheet at the end of 6 August 2013, the day beforethe transaction of the empirical test was undertaken. Supplementarymaterial 4 in online Appendix 3 shows the daily balance of the followingday. In Table 6 the key asset positions are summarised and accountnames translated, for the end of the day prior to the loan experiment,and for the end of the day on which the researcher had borrowed themoney. Table 7 shows the key liability positions for the same periods:

Starting by analysing the liability side information (Table 7), we findthat customer deposits are considered part of the financial institution'sbalance sheet. This contradicts the financial intermediation theory, whichassumes that banks are not special and are virtually indistinguishablefrom non-bank financial institutions that have to keep customer de-posits off balance sheet. In actual fact, a bank considers a customers' de-posits starkly differently from non-bank financial institutions, whorecord customer deposits off their balance sheet. Instead we find thatthe bank treats customer deposits as a loan to the bank, recordedunder rubric ‘claims by customers’, who in turn receive as record oftheir loans to the bank (called ‘deposits’) what is known as their

The empirical researcher's new bank account balances.

Accounts' overview

EUR Credit Liabilities Balance No. contracts

Current account 200,000.00 200,000.00 1Loan 200,000.00 −200,000.00 1

Bank sum total 200,000.00 200,000.00 0.00 2

Table 6RaiffeisenbankWildenberg e.G.: daily accounts' assets.6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.EUR.

Assets Balance 6 Aug.2013

Balance 7 Aug.2013

Difference

1. Cash 181,703.03 340,032.89 158,329.862. Bills of exchange3. Claims on financial. inst. 5,298,713.76 5,079,709.21 −219,004.554. Claims on customers 23,712,558.13 23,947,729.92 235,171.79

–Maturing daily 932,695.44 967,767.32 35,071.88–Maturity under 4 years 1,689,619.97 1,889,619.97 200,000.00–Maturity 4 years or longer 21,090,242.72 21,090,342.72 100.00

5. Bonds, bills, debt instr. 19,178,065.00 19,178,065.006. Stocks and shares7. Stake holdings 397,768.68 397,768.688. Stakes in related firms9. Trust assets 5262.69 5262.6910. Compensation claims on thepublic sector11. Immaterial assets 102.00 102.0012. Fixed assets 221,549.46 221,549.4613. Called but not deployed capital14. Other assets 707,569.26 711,288.64 3719.3815. Balancing item 2844.32 2844.3216. Sum of assets 49,706,136.33 49,884,352.81 178,216.48


‘account statement’. This can only be reconciled with the credit creationor fractional reserve theories of banking.

We observe that an amount not far below the loan balance (about€190,000) has been deposited with the bank. This is itself not far fromthe increase in total liabilities (and assets). Since the fractional reservehypothesis requires such an increase in deposits as a precondition forbeing able to grant the bank loan, i.e. it must precede the bank loan, itis difficult to reconcile this observationwith the fractional reserve theory.Moreover, the researcher confirmed that in his own bank account theloan balance of €200,000 was shown on the same day. This meansthat the increase in liabilities was driven by the increase by €200,000in daily liabilities (item 2B BA in Table 7). Thus the total increase in lia-bilities could not have been due to a coincidental increase in customerdeposits on the day of the loan. The liability side account informationseems only fully in line with the credit creation theory.

Turning to an analysis of the asset side, we note that the categorywhere we find our loan is item 4, claims on customers — fortunatelythe only one that day with a maturity below 4 years and hence clearlyidentifiable on the bank balance sheet. Apparently, customers also tookout short-term loans (most likely overdrafts) amounting to €35,071.88,producing a total new loan balance of €235,071.88. In order to keep theanalysis as simple as possible, let us proceed from here assuming that

Table 7RaiffeisenbankWildenberg e.G.: daily accounts' liabilities.6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.EUR.

Liabilities Balance 6 Aug.2013

Balance 7 Aug.2013

Difference

1. Claims by financial inst. 5,621,456.60 5,621,879.66 423.062. Claims by customers 39,589,177.09 39,759,156.42 169,979.33

2A. Savings accounts 10,234,806.01 10,237,118.24 2312.232B. Other liabilities 29,354,371.08 29,522,038.18 167,667.10–BA daily 13,773,925.93 13,963,899.89 189,973.96–BB maturity less 4 years 13,296,042.92 13,273,736.06 −22,306.86–BC maturity 4 years or longer 2,284,402.23 2,284,402.23

4. Trust liabilities 5262.70 5262.705. Other liabilities 12,378.81 12,599.44 220.636. Balancing item 16,996.04 16,996.047. Reserves 1,138,497.64 1,138,497.6411. Fund for bank risk 250,000.00 250,000.0012. Own capital 3,057,248.57 3,057,248.5713. Sum liabilities 49,706,136.33 49,884,352.81 178,216.48

our test loan amounted to this total loan figure (€235,071.88). So the bal-ance sheet item of interest on the asset side is ΔA4, the increase in loans(claims on customers) amounting to €235,071.88.

We now would like to analyse the balance sheet in order to seewhether this new loan of €235,071.88 was withdrawn from other ac-counts at the bank, or how else it was funded. We first proceed withconsidering activity on the asset side. Denoting balances in thousandsbelow, we can summarise the balance sheet changes during theobservation period, within the balance sheet constraints as follows:

ΔAssets ¼ ΔA1 cashð Þ þ ΔA3 claims on other FIð Þþ ΔA4 claims on customersð Þ þ ΔA14 other assetsð Þ: ð1Þ

Numerically, these are, rounded in thousand euro:

178 ¼ 158−219þ 235þ 4: ð2Þ

The fractional reserve theory says that the loan balance must be paidfrom reserves. These can be either cash balances or reserves with otherbanks (including the central bank). The deposits (claims) with otherfinancial institutions (which effectively includes the bank's centralbank reserve balances) declined significantly, by €219,000. At thesame time cash reserves increased significantly. What may have hap-pened is that the bank withdrew legal tender from its account withthe cooperative central bank, explaining both the rise in cash and de-cline in balances with other financial institutions. Since the theories donot distinguish between these categories, we can aggregate A1 andA3, the cash balances and reserves. Also, to simplify, we aggregate A14(other assets) with A4 (claims on customers), to obtain:

178ΔAssetsð Þ

¼ −61Δreservesð Þ

þ239Δclaims on customers; othersð Þ : ð3Þ

We observe that reserves fell, while claims on customers rose signif-icantly. Moreover, total assets also rose, by an amount not dissimilar toour loan balance. Can this information be reconciled with the threetheories of banking?

Considering the financial intermediation hypothesis, wewould expect adecline in reserves (accountswith otherfinancial institutions and cash) ofthe same amount as customer loans increased. Reserves however de-clined by far less. At the same time, the balance sheet expanded, drivenby a significant increase in claims on customers. If the bank borrowedmoney from other banks in order to fund the loan (thus reducing its bal-ance of net claims onother banks), in linewith the financial intermediationtheory of banking, vault cash should not increase and neither should thebalance sheet. We observe both a significant rise in cash holdings andan expansion in the total balance sheet (total assets and total liabilities),which rose by€178,000. This cannot be reconciledwith thefinancial inter-mediation theory, which we therefore must consider as rejected.

Considering the fractional reserve theory, we confirmed by asking thecredit department's Mr. Keil, as well as the directors, that none of themchecked their reserve balance or balance of deposits with other banks be-fore signing the loan contract and making the funds available to the bor-rower (see the translated letter in Appendix 2, and the original letter inthe online Appendix 3. Furthermore, there seems no evidence that re-serves (cash and claims on other financial institutions) declined in anamount commensurate with the loan taken out. Finally, the observed in-crease in the balance sheet can also not be reconciled with the standarddescription of the fractional reserve theory. We must therefore considerit as rejected, too.

This leaves us with the credit creation theory. Can we reconcile theobserved accounting asset side information with it? And what do welearn from the liability side information?

The transactions are linked to each other via the accounting identitiesof the balance sheet (Eqs. (1), (2) and (3)).We can therefore ask theques-tion what would have happened to total assets, if we assumed for the

32 Thanks to Charlie Haswell for the ‘fairy dust’ allegory.


moment that no other transaction had taken place, apart from the loan(235). We can set the change in each asset item (except for ΔA4, ourloan) to zero, if we subtract the same amount from the change in total as-sets. The new total asset balance in this hypothetical scenario would be:

178−158þ 219−4 ¼ 235 ð4Þ

or, in general,

ΔA4 claims on customersð Þ ¼ ΔAssets−ΔA1 cashð Þ−ΔA3 claims on other FIð Þ−ΔA14 other assetsð Þ: ð5Þ

In other words, if the other transactions had not happened, thebank's balance sheet would have expanded by the same amountas the loans taken out. This finding is consistent only with the creditcreation theory of bank lending.

The evidence is not as easily interpreted as may have beendesired, since in practice it is not possible to stop all other banktransactions that may be initiated by bank customers (who are now-adays able to implement transactions via internet banking even onholidays). But the available accounting data cannot be reconciledwith the fractional reserve and the financial intermediation hypothe-ses of banking.

5. Conclusion

This paper was intended to serve two functions. First, the history ofeconomic thoughtwas examined concerning the question of how banksfunction. It was found that a long-standing controversy exists that hasnot been settled empirically. Secondly, empirical tests were conductedto settle the existing and continuing controversies and find out whichof the three theories of banking is consistent with the empiricalobservations.

5.1. Three theories but no empirical test

Concerning the first issue, in this paper we identified three dis-tinct hypotheses concerning the role of banks, namely the credit cre-ation theory, the fractional reserve theory and the financialintermediation theory. It was found that the first theory was domi-nant until about the mid- to late 1920s, featuring leading proponentssuch as Macleod and Schumpeter. Then the second theory becamedominant, under the influence of such economists as Keynes, Crick,Phillips and Samuelson, until about the early 1960s. From the early1960s, first under the influence of Keynes and Tobin and the Journalof Money, Credit and Banking, the financial intermediation theory be-came dominant.

Yet, despite these identifiable eras of predominance, doubts haveremained concerning each theory. Most recently, the credit creationtheory has experienced a revival, having been championed again inthe aftermath of the Japanese banking crisis in the early 1990s(Werner, 1992, 1997) and in the run-up to and aftermath ofthe European and US financial crises since 2007 (see Bank ofEngland, 2014b; Benes & Kumhof, 2012; Ryan-Collins, Greenham,Werner, & Jackson, 2011, 2012;Werner, 2003a, 2005, 2012). Howev-er, such works have not yet become influential in the majority ofmodels and theories of the macro-economy or banking. Thus it hadto be concluded that the controversy continues, without any scientif-ic attempt having been made at settling it through empiricalevidence.

5.2. The empirical evidence: credit creation theory supported

The second contribution of this paper has been to report on the firstempirical study testing the threemain hypotheses. They have been suc-cessfully tested in a real world setting of borrowing from a bank and

examining the actual internal bank accounting in an uncontrolled realworld environment.

It was examined whether in the process of making money availableto the borrower the bank transfers these funds from other accounts(within or outside the bank). In the process of making loaned moneyavailable in the borrower's bank account, it was found that the bankdid not transfer the money away from other internal or external ac-counts, resulting in a rejection of both the fractional reserve theory andthe financial intermediation theory. Instead, it was found that the banknewly ‘invented’ the funds by crediting the borrower's account with adeposit, although no such deposit had taken place. This is in line withthe claims of the credit creation theory.

Thus it can now be said with confidence for the first time – possiblyin the 5000 years' history of banking - that it has been empirically dem-onstrated that each individual bank creates credit and money out ofnothing, when it extends what is called a ‘bank loan’. The bank doesnot loan any existing money, but instead creates new money. Themoney supply is created as ‘fairy dust’ produced by the banks out ofthin air.32 The implications are far-reaching.

5.3. What is special about banks

Henceforth, economists need not rely on assertions concerningbanks. We now know, based on empirical evidence, why banks are dif-ferent, indeed unique— solving the longstanding puzzle posed by Fama(1985) and others— and different from both non-bankfinancial institu-tions and corporations: it is because they can individually create moneyout of nothing.

5.4. Implications

5.4.1. Implications for economic theoryThe empirical evidence shows that of the three theories of banking,

it is the one that today has the least influence and that is being belittledin the literature that is supported by the empirical evidence. Further-more, it is the theory whichwaswidely held at the end of the 19th cen-tury and in the first three decades of the twentieth. It is sobering torealise that since the 1930s, economists havemoved further and furtheraway from the truth, instead of coming closer to it. This happened firstvia the half-truth of the fractional reserve theory and then reached thecompletely false and misleading financial intermediation theory thattoday is so dominant. Thus this paper has found evidence that therehas been no progress in scientific knowledge in economics, financeand banking in the 20th century concerning one of the most importantand fundamental facts for these disciplines. Instead, there has been a re-gressive development. The known facts were unlearned and have be-come unknown. This phenomenon deserves further research. For nowit can be mentioned that this process of unlearning the facts of bankingcould not possibly have taken place without the leading economists ofthe day having played a significant role in it. Themost influential and fa-mous of all 20th century economists, aswe saw,was a sequential adher-ent of all three theories, which is a surprising phenomenon. Moreover,Keynes used his considerable clout to slow scientific analysis of thequestion whether banks could create money, as he instead engaged inad hominem attacks on followers of the credit creation theory. Despitehis enthusiastic early support for the credit creation theory (Keynes,1924), only six years later he was condescending, if not dismissive, ofthis theory, referring to credit creation only in inverted commas. Hewas perhaps even more dismissive of supporters of the credit creationtheory, who he referred to as being part of the “Army of Heretics andCranks, whose numbers and enthusiasm are extraordinary”, and who


seem to believe in “magic” and some kind of “Utopia” (Keynes, 1930,vol. 2, p. 215).33

Needless to mention, such rhetoric is not conducive to scientific ar-gument. But this technique was followed by other economists engagedin advancing the fractional reserve and later financial intermediationtheories. US Federal Reserve staffer Alhadeff (1954) argued similarlyduring the era when economists worked on getting the fractional re-serve theory established:

“One complication worth discussing concerns the alleged “creation”of money by bankers. It used to be claimed that bankers could createmoney by the simple device of opening deposit accounts for theirbusiness borrowers. It has since been amply demonstrated that un-der a fractional reserve system, only the totality of banks can expanddeposits to the full reciprocal of the reserve ratio. [Original footnote:‘Chester A. Phillips, Bank Credit (New York: Macmillan, 1921),chapter 3, for the classical refutation of this claim.’] The individualbank can normally expand to an amount about equal to its primarydeposits” (p. 7).

The creation of credit by banks had become, in the style of Keynes(1930), an “alleged ‘creation’”, whereby rhetorically it was suggestedthat such thinking was simplistic and hence could not possibly betrue. Tobin used the rhetorical device of abductio ad absurdum to den-igrate the credit creation theory by incorrectly suggesting it postulateda ‘widow's cruse’, a miraculous vessel producing unlimited amounts ofvaluable physical goods, and thus its followers were believers in mira-cles or utopias.

This same type of rhetorical denigration of and disengagement withthe credit creation theory is also visible in the most recent era. For in-stance, the New Palgrave Money (Eatwell et al., 1989), is an influential340-page reference work that claims to present a ‘balanced perspectiveon each topic’ (Eatwell et al., 1989, p. viii). Yet the financial intermediationtheory is dominant, with a minor representation of the fractional reservetheory. The credit creation theory is not presented at all, even as a possibil-ity. But the book does include a chapter entitled “Monetary cranks”. Inthis brief chapter, Keynes' (1930) derogatory treatment of supportersof the credit creation theory is updated for use in the 1990s, with sharp-ened claws: Ridicule and insult is heaped on several fateful authorsthat have produced thoughtful analyses of the economy, the monetarysystem and the role of banks, such as Nobel laureate Sir FrederickSoddy (1934) and C.H. Douglas (1924). Even the seminal and influentialwork by Georg Friedrich Knapp (1905), still favourably cited by Keynes(1936), is identified as being created by a ‘crank’. What these apparentlywretched authors have in common, and what seems to be their mainfault, punishable by being listed in this inauspicious chapter, is that

33 “There is a common element in the theories of nearly all monetary heretics. Their the-ories ofMoney and Credit are alike in supposing that in someway the banks can furnish allthe real resources which manufacture and trade can reasonably require without real costto anyone…. For they argue thus. Money (meaning loans) is the life-blood of industry. Ifmoney (in this sense) is available in sufficient quantity and on easy terms, we shall haveno difficulty in employing to the full the entire available supply of the factors of produc-tion. For the individual trader or manufacturer “bank credit” means “working capital”; aloan from his bank furnishes him with the means to pay wages, to buy materials and tocarry stocks. If, therefore, sufficient bank credit was freely available, there need never beunemployment. Why then, he asks, if the banks can create credit, should they refuse anyreasonable request for it? And why should they charge a fee for what costs them little ornothing?… There can only be one answer: the bankers, having a monopoly of magic, ex-ercise their powers sparingly in order to raise the price. … Where magic is at work, thepublic do not get the full benefit unless it is nationalised. Our heretic admits, indeed, thatwe must take care to avoid “inflation”; but that only occurs when credit is created whichdoes not correspond to any productive process. To create credit tomeet a genuine demandfor working capital can never be inflationary; for such a credit is “self-liquidating” and isautomatically paid off when theprocess of production isfinished.… If the creation of cred-it is strictly confined within these limits, there can never be inflation. Further, there is noreason for making any charge for such credit beyond what is required to meet bad debtsand the expense of administration. Not a week, perhaps not a day or an hour, goes by inwhich some well-wisher of mankind does not suddenly see the light — that here is thekey to Utopia” (vol. 2, pp. 217 ff.).

they are adherents of the credit creation theory. But, revealingly, theircontributions are belittled without it anywhere being stated what theirkey tenets are and that their analyses centre on the credit creation theory,which itself remains unnamed and is never spelled out. This is not a smallfeat, and leaves one pondering the possibility that the Eatwell et al.(1989) tome was purposely designed to ignore and distract from therich literature supporting the credit creation theory. Nothing lost, accord-ing to the authors, who applaud the development that due to

“the increased emphasis given to monetary theory by academiceconomists in recent decades, themonetary cranks have largely dis-appeared from public debate …” (p. 214).

And so has the credit creation theory. Since the tenets of this theoryare never stated in Eatwell et al. (1989), the chapter on ‘Cranks’ endsup being a litany of ad hominem denigration, defamation and characterassassination, liberally distributing labels such as ‘cranks’, ‘phrase-mon-gers’, ‘agitators’, ‘populists’, and even ‘conspiracy theorists’ that believein ‘miracles’ and engage in wishful thinking, ultimately deceiving theirreaders by trying to “impress their peers with their apparent under-standing of economics, even though they had no formal training in thediscipline” (p. 214). All that we learn about their actual theories isthat, somehow, these ill-fated authors are “opposed to private banksand the ‘Money Power’without their opposition leading tomore sophis-ticated political analysis” (p. 215). Any reading of the highly sophisticat-ed Soddy (1934) quickly reveals such labels as unfounded defamation.

To the contrary, the empirical evidence presented in this paper has re-vealed that themany supporters of the financial intermediation theory andalso the adherents of the fractional reserve theory are flat-earthers that be-lieve in what is empirically proven to be wrong and which should havebeen recognisable as being impossible upon deeper consideration of theaccounting requirements. Whether the authors in Eatwell et al. (1989)did in fact know better is an open question that deserves attention in fu-ture research. Certainly the unscientific treatment of the credit creationtheory and its supporters by such authors as Keynes, who strongly en-dorsed the theory only a few years before authoring tirades against itssupporters, or by the authors in Eatwell et al. (1989), raises thispossibility.

5.4.2. Implications for government policyThere are other, far-reaching ramifications of the finding that banks

individually create credit and money when they do what is called‘lending money’. It is readily seen that this fact is important not onlyfor monetary policy, but also for fiscal policy, and needs to be reflectedin economic theories. Policies concerning the avoidance of bankingcrises, or dealing with the aftermath of crises require a different shapeonce the reality of the credit creation theory is recognised. They call fora whole new paradigm in monetary economics, macroeconomics,finance and banking (for details, see for instance Werner, 1997, 2005,2012, 2013a,b) that is based on the reality of banks as creators of themoney supply. It has potentially important implications for other disci-plines, such as accounting, economic and business history, economicgeography, politics, sociology and law.

5.4.3. Implications for bank regulationThe implications are far-reaching for bank regulation and the design

of official policies. As mentioned in the Introduction, modern nationaland international banking regulation is predicated on the assumptionthat the financial intermediation theory is correct. Since in fact banksare able to create money out of nothing, imposing higher capital re-quirements on banks will not necessarily enable the prevention ofboom–bust cycles and banking crises, since even with higher capital re-quirements, banks could still continue to expand the money supply,thereby fuelling asset prices, whereby some of this newly createdmoney can be used to increase bank capital. Based on the recognitionof this, some economists have argued for more direct intervention by


the central bank in the credit market, for instance via quantitative creditguidance (Werner, 2002, 2003a, 2005).

5.4.4. Monetary reformThe Bank of England's (2014b) recent intervention has triggered a

public debate about whether the privilege of banks to create moneyshould in fact be revoked (Wolf, 2014). The reality of banks as creatorsof themoney supply does raise the question of the ideal type ofmonetarysystem.Much research is neededon this account. Among themany differ-ent monetary system designs tried over the past 5000 years, very fewhavemet the requirement for a fair, effective, accountable, stable, sustain-able and democratic creation and allocation ofmoney. The viewof the au-thor, based on more than twenty-three years of research on this topic, isthat it is the safest bet to ensure that the awesome power to createmoney is returned directly to those to whom it belongs: ordinary people,not technocrats. This can be ensured by the introduction of a network ofsmall, not-for-profit local banks across the nation. Most countries do notcurrently possess such a system. However, it is at the heart of the success-ful German economic performance in the past 200 years. It is the veryRaiffeisen, Volksbank or Sparkasse banks – the smaller the better – thatwere helpful in the implementation of this empirical study that shouldserve as the role model for future policies concerning our monetary sys-tem. In addition, one can complement such local public bank moneywith money issued by local authorities that is accepted to pay localtaxes, namely a local public money that has not come about by creatingdebt, but that is created for services rendered to local authorities or thecommunity. Both forms of local money creation together would create adecentralised and more accountable monetary system that should per-form better (based on the empirical evidence from Germany) than theunholy alliance of central banks and big banks, which have done muchto create unsustainable asset bubbles and banking crises (Werner,2013a,b).

Appendix 1. Sequence of steps for the extension of a loanRaiffeisenbankWildenberg e.G.

1. Negotiations concerning the details of the loan.2. Receipt of KYC information and opening of a new customer file

(new customer).3. Opening of a current account (new customer).4. Calculation of the loan and repayment schedule, model calculation,

European required customer notification information, record ofcustomer advisory.

5. Entry of loan application into the bank IT system.6. Check of ability to service and repay the loan/conducting liquidity

calculation in loan application.7. Credit rating of customer, entry into customer file.8. Search of customer data on central bank data base for singular eco-

nomic dependencies and entry of results into bank IT.9. Bank board recommendation on loan application with justification

(2 directors).10. Print out of loan contract, general loan conditions, with handover

receipted by customer.11. Print out of the protocol of the loan process.12. Approval of credit by bank directors by signing the protocol and the

loan contract.13. Creation of loan account in the IT system.14. Establishment of credit limit and availability of credit.15. Appointment with customer.16. Customer signs credit documents.17. Payment of loan at the value date, in exchange for evidence

of use of the loan in line with the declared use in the loanapplication.

Appendix 2. Letter of confirmation of facts by RaiffeisenbankWildenberg e.G. (Translation; original in online Appendix 3).

10 June 2014

Dear Prof. Dr. Werner,

Confirmation of Facts

In connection with the extension of credit to you in August 2014 I ampleased to confirm that neither I as director of RaiffeisenbankWildenbergeG, nor our staff checked either before or during the granting of the loanto you, whether we keep sufficient funds with our central bank, DZ BankAG, or the Bundesbank.We also did not engage in any such related trans-action, nor did we undertake any transfers or account bookings in ordertofinance the credit balance in your account. Thereforewedidnot engagein any checks or transactions in order to provide liquidity.

Yours sincerely,

M. Rebl,Director, Raiffeisenbank Wildenberg e.G.

Appendix 3. Supplementary data

Supplementary data to this article can be found online at http://dx.doi.org/10.1016/j.irfa.2014.07.015.

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